A tax shelter is a financial vehicle that an individual can use to help them lower their tax obligation and, thus, keep more of their money. It is a legal way for individuals to “stash” their money and avoid getting it taxed.
A tax shelter is entirely different from a tax haven because the latter exists outside the country and its legality can, at times, be questionable. A tax shelter, on the other hand, is entirely legal and keeps all monies within an individual’s home country. In the United States, some of the most commonly used tax shelters are home equity and 401(k) retirement accounts.
Examples of Tax Shelters
1. Home equity
It is common for many individuals or individuals to purchase a home, either outright or through a mortgage loan. Home equity is the value of the home that the home buyer owns free and clear of any debt. The tax shelter portion of home equity occurs in the event that the individual – at some point – decides to sell their home.
A 401(k) account is a tax shelter; however, it’s not a permanent one. As an individual pays into their 401(k) account with pre-tax income, the amount of income that the government can tax becomes smaller. The money in the account is allowed to earn interest without the government taking taxes from it. The tax shelter isn’t permanent because, at some point in the future, the individual will need to pay taxes on the income. Regular tax deductions will be taken once the individual begins removing money from the account.
A traditional individual retirement account (IRA) is another example of a tax shelter and works in nearly the same way as a 401(k) account.
Using Deductions as a Tax Shelter
Sometimes, in order to save money, you must spend money. It is true if you plan to use deductions as a tax shelter. Essentially, it means buying things that are known to offer tax benefits. The money spent may be partially regained through tax credits or tax reductions.
Deductions are taken on a wide variety of things. Tuition can be paid to a college with a loan instead of a line of credit, and the student loan interest deduction can be taken advantage of. Also, there are a variety of purchases or donations (many of which involve charities) that are at least partially tax-deductible.
Tax shelters are important, although they can sometimes be looked at in a negative way. Such financial tools allow individuals to help retain more of the money they earn or get back some of the money they spend through deductions. They are a legal way to stop the government from taxing part of your income.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:
Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes.
These courses will give the confidence you need to perform world-class financial analyst work. Start now!
Building confidence in your accounting skills is easy with CFI courses! Enroll now for FREE to start advancing your career!