You’ve probably heard the words ‘tax shelter’ at some point, in the context of wealthy people trying to reduce the amount of taxes they need to pay. Sometimes there is a negative connotation implied, as if the practice is illegal or immoral. In truth, tax shelters are not only for the wealthy and are a legal and useful tool for everyone to reduce their income tax burden. A little bit of tax planning early in the year can allow you to take advantage of this valuable resource.
What is a Tax Shelter?
A tax shelter is any one of a variety of ways that taxpayers can reduce the amount of tax they will owe by separating it from their taxable income. This can be done by investing the money, for example, in a 401(k), or by purchasing certain types of bonds. Tax credits and deductions provided by the IRS are also forms of tax shelters. For example, deductions for charitable donations and mortgage interest paid help to reduce taxable income and are therefore considered tax shelters.
Tax Shelter Does Not Mean Tax Evasion
There is an important distinction to be made between the legal practice of tax sheltering and illegal tax evasion. Tax evasion is the result of manipulating tax sheltering rules to benefit an individual or company. For instance, a small business owner claiming 100% of their home and vehicle cost as business expenses is committing tax evasion – whether knowingly or not. However, claiming a reasonable amount of home and vehicle costs, in accordance with the IRS rules, is a legal form of tax sheltering. If you own a small business or are self-employed, get the advice of an expert in tax preparation to ensure that you do not inadvertently overstate expenses on your tax return.
Tax-Free Growth and Interest
While tax sheltering investments such as retirement savings investments and mutual fund investments will help reduce the amount of tax you owe now, there are also future benefits. For example, money invested in a 401(k) or 403(b) will provide a tax credit to be used in the year the investment is made, reducing your tax burden today. As the investment grows, it does so without any additional taxation. In retirement, when most people’s income is reduced, the money will be withdrawn and taxed at a much lower tax rate.
Tax shelters are useful tools in tax planning, offering multiple ways to reduce your tax burden either by claiming deductions and credits or by deferring the taxation of the income to the future when your tax rate is lower. They are legal and available to everyone, so why not do a little tax planning and save yourself this year.
E&Y Agency is a tax preparation firm in Troy, Michigan, and serving clients in the surrounding areas of Sterling Heights, Shelby Township, Macomb, Rochester, Rochester Hills, and Royal Oak. Call us to talk about tax planning in advance of the next tax season.
