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What Is a Tax Shelter?

A tax shelter is a legal means of reducing taxable income. Lowering taxable income also reduces tax liability. Tax shelters include real estate investments, municipal bonds, 401(k) and 403(b) plans, Individual Retirement Accounts (IRAs), certain pension plans, and employer-sponsored health coverage or life insurance.

Tax shelters may have a negative connotation because of news reports regarding investors who illegally hide their income. However, offshore accounts and means of concealing income don’t fit the tax shelter definition.

Tax-Sheltered Annuity

One way a tax shelter reduces taxable income is by deferring that income to a later date. Retirement plans like a 401(k) or tax-sheltered annuity (TSA) allow employees to deduct their contributions for the year. Funds are taxed at a lower rate after the participant reaches 59 ½ and begins making withdrawals.

While 401(k) plans are available to anyone working in a privately-owned business, TSAs are slightly different. They are only available to people working non-profit agencies such as a charity, church, or educational facility. A 403(b) plan is a type of tax-sheltered annuity.   

Tax Shelter Investments

Certain investments may be tax exempt or taxed at a reduced rate. Legitimate tax shelter investments are designed to generate income. Avoid illegal investments that hide funding sources or create the appearance of loss.

Municipal Bonds

Municipal bonds are issued by federal, state, or local government. The generated funds are used for projects that benefit the public, such as schools, roads bridges, or sewer systems. Most municipal bonds are exempt from federal, state, and local taxes.

Roth IRAs

Consider setting aside a few thousand dollars for each of your children in a Roth IRA. By the time beneficiaries turn 60, the account may be worth $50,000 or more. It can also save on inheritance taxes since the fund is already in the recipient’s name.

Section 529 Plans

A Section 529 plan allows investments to grow tax-free, provided the earnings are used for education. High fees can erode any tax benefit, so make sure this type of college fund fits your portfolio before making an investment. If your child is eligible for tuition assistance, any earnings made through a 529 plan will count against the amount they can receive.

Master Limited Partnerships (MLPs)

MLPs are publicly traded limited partnerships that pay dividends on real estate, natural resources, or commodities. Limited partners receive quarterly payouts. Taxes are only paid when shareholders receive funds, not on profits. MLP investments are eligible for tax breaks for up to 20 years.

Home Ownership

Homeowners also benefit from tax breaks. The interest on a mortgage is deductible for an up to $100,000 loan, and property taxes are deductible as well. The biggest tax benefit comes when you sell the home. Up to $250,000 in profit is excluded from taxes for single homeowners, and married couples can exclude up to $500,000 in capital gains.

Real Estate Tax Shelters

Rental properties provide a dual source of income: rent monies and property depreciation. The government recognizes that property devalues over time. Residential property depreciates over a 27 ½ year period, and non-residential property depreciates over 39 years. Depreciation is calculated on improvements to the property; the land itself never depreciates.

Each year the landlord may claim a loss equal to that year’s portion of depreciated value. This loss offsets rental income and excludes part of it from taxation.

Many opportunities are available for savvy investors to take advantage of tax benefits. Ask an Expert to determine whether a particular type of investment is right for you.

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