Mention the term “tax shelter” and what might come to mind are millionaires and billionaires who turn to offshore accounts (or Switzerland) to stash their funds so the U.S. government doesn’t tax them.
This is the dramatic version of tax shelters. The more realistic definition? A tax shelter is a technique or tool used by taxpayers to reduce any type of taxable income. Delving further into this concept, tax shelters are perfectly legal, and can include investment and investment accounts that offer favorable tax treatments.
Keep in mind that you really can’t “shield” your earned income from taxes. Rather, sheltering your income from taxes relies on a combination of deductions made up of expenses, credits, and even workplace benefits.
Let’s take a look at some of the more popular methods of sheltering income from taxes.
Investment/Retirement Accounts
One of the more common types of tax shelters involves retirement savings accounts. In other words, you direct a certain amount of your pre-tax income into these accounts, with taxes deferred until withdrawal (though the Roth IRA is an exception; more on this, below).
Such accounts include:
401(k)
The 401(k) is offered by your employer as a benefit. Part of the IRC’s 26 U.S. Code § 401 – “Qualified Pension, Profit-sharing, and Stock Bonus Plans,” this tax-advantaged structure is in place to help employees save for their retirement. The IRS has annual limits as to how much you can contribute to this account; the 2022 annual limit is $22,500.
403(b)
While the 401(k) is offered by private employers, the 26 U.S. Code § 403 – “Taxation of Employee Annuities” is offered through public and non-profit organizations: Think public schools colleges and universities, as well as 501(c)(3) entities. Though similar in many ways to 401(k)s in that this is a tax-shelter product, the 403(b) is classified as a tax-sheltered annuity (TSA). An annuity is a contract between yourself and an insurance company, meaning that your plan will be administered by that company, versus a mutual fund company.
Individual Retirement Accounts
The IRA is an investment tool you’d use to allocate funds for retirement. There are two types of IRAs:
- The traditional IRA, in which contributions are tax deductible. When you withdraw from this account, the funds are taxed at your ordinary income rate.
- The Roth IRA, which contributions are not tax deductible. However, you don’t incur taxes when withdrawing from the account during retirement.
Real Estate
Real estate has been recognized as a viable shelter for income. Homeowners can deduct mortgage interest and property taxes (though the Tax Cut and Jobs Act of 2017 limited some of these deductions). You can also take an interest deduction if your rental property has a mortgage. Furthermore, you can deduct a portion of your investment expenses—known as depreciation—on your taxes. But keep in mind that once you sell that property, you’re liable for depreciation recapture taxes.
To help defer both depreciation recapture and capital gains taxes, you could utilize a 1031 exchange to invest in a different real estate asset.
Workplace Benefits
Some workplace benefits, such as health or accident insurance, might not be considered actual wages or salary by the IRS. As such, these non-compensation benefits aren’t subject to social security, Medicare, or federal income tax withholding. However, health coinsurance costs need to be included in wages of S corporation employees who own more than 2% of said corporation.
Sheltering versus Avoiding
The important issue to keep in mind is that tax sheltering is far different from tax avoidance. Many investments and instruments are available to help you keep the income you earn by deferring taxes. To help develop an effective tax shelter strategy, be sure to work with your financial adviser and/or tax professional.
