What is a Tax Shelter? [The Ultimate Guide For 2021]

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We all want to reduce our tax liabilities but are not quite sure how to go about it. Taxes are intimidating and trying to reduce them sounds even more complicated. But there are a few legal ways you can reduce your taxes, including a tax shelter. But what is a tax shelter? This article addresses different types of tax shelters and how they work.

What is a Tax Shelter?

A legal tax shelter is a vehicle used by individuals or businesses to reduce their tax liabilities. It should not be confused with illegal ways of tax exemption.

How Does Tax Sheltering Work?

Tax sheltering works by reducing your taxable income. Although there are a few legal ways to minimize your taxes, sheltering is one of the easiest methods to use by making, for example, pre-tax contributions to tax shelters, reducing your taxable income, and thereby reducing your tax liabilities. If you earn $20,000 annually, for example, and utilize tax shelters worth $5,000, your taxable income reduces to $15,000, leading to tax deductions of $5,000.

NOTE: Tax relief companies also utilize the help of tax shelters to reduce your taxes and increase your investments.

Types of Tax Shelters

Let’s look at the types of tax shelters:

Retirement accounts

There are many retirement accounts, such as 401(k), 401 (b), Roth IRA, and Roth 401(k). The 401(k) should not be confused with pensions. These accounts allow you, as a taxpayer, to transfer a part of your taxable income. The interest or profits earned are also tax-free, which serves the dual purpose of maximizing tax returns and increasing your retirement funds.

Municipal bonds

Another type of tax shelter is municipal bonds, a form of fixed investment, similar to buying bonds of a corporate firm. Such bonds not only offer tax-free returns but also reduces your taxable income.

Mutual funds

Similar to municipal bonds, mutual funds invested in the government are also an excellent option to consider. It will not directly reduce your taxable income, but the interest earned on government mutual funds is tax-free.

Foreign investments

Such investments involve investing in assets outside your country, which is considered one of the best tax shelter investments you can make. With such investments, you must pay tax on your profits to a foreign government and not to the IRS. But this will reduce your taxable income.

Medical savings account

Like retirement accounts, health accounts also allow you to transfer a part of your income into it. It not only reduces your taxable income but also provides you medical security in case of unforeseen incidents.

Real estate

Buying stock in real estate is an investment. And if you hold that stock for over one year, you would be charged long-term capital gains rather than ordinary income tax. So a real estate tax shelter is a good option if you want to invest and reduce your taxable income at the same time.

Charitable contributions

Charitable donations to IRS-recognized institutions are also tax deductibles; that is, the donations you make to charity are deducted from your income, thereby reducing your taxable income.

Workplace benefits

Workplace benefits—such as achievement awards, educational assistance, or retirement plans—are a way to avoid taxes and reduce your taxable income.

Key Takeaways

A tax shelter is a method used by businesses and individuals to reduce their tax liabilities.
Tax shelters work by reducing your taxable income, thereby reducing your taxes.
The most common tax shelter is through such retirement accounts as a 401(k), 401 (b), Roth IRA, or a Roth 401(k).
Other tax shelters include mutual funds, municipal bonds, real estate investment, and charitable donations.

Tax Shelter vs Tax Avoidance

Both of these terms are different from each other but serve the same purpose. Tax shelters allow investing to reduce taxable income. Tax avoidance involves tax deductions in pre-tax income to reduce taxable income and increase tax credits. For example, if your income is $10,000 per year and your tax deductions stand at $1,000, your taxable income reduces to $9,000. Tax avoidance, then, is a legal way to reduce taxes rather than investing money.

It’s essential to pay taxes on time, amend mistakes in tax returns, and seek the help of free tax consultants to manage your taxes to ensure you’re engaging in legal ways to reduce your taxable income.

NOTE: You can also seek the help of various affordable tax services to determine the appropriate tax shelter for you.

Conclusion

Income tax shelters are legal ways in which an individual or business can reduce their taxable income and can serve as good investment options, such as those seen in retirement accounts, medical savings account, mutual funds, and municipal bonds. Tax shelters, however, should not be confused with illegal tax avoidance.

FAQ

What is the biggest tax shelter for taxpayers?

Various retirement plans are one of the biggest tax shelters for taxpayers. Retirement plans include 401(k), 401 (b), Roth IRA, and Roth 401(k).

How to shelter income from taxes?

You can seek the help of various tax shelters, such as retirement plans, municipal bonds, foreign investments, and medical savings accounts.

What makes a tax shelter illegal?

What is a tax shelter? It’s a legal way to reduce your taxes, as well as invest your money. But the sole purpose of Illegal tax shelters is to evade taxes, often involving complex transactions.

ABOUT AUTHOR

I learned a lot about finance after working for a digital marketing company specializing in investing and trading stocks, forex, etc. After that, I got exposed to other verticals such as wealth management and personal finance, which further improved my understanding of the financial world.

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