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Tax shelters: What they are and how to use them

At a glance:

"Tax sheltering" is not necessarily a bad word, or immoral or illegal. The US Supreme Court has upheld taxpayers' rights to pay the lowest tax possible using legal devices and means.

The IRS itself provides many opportunities for taxpayers to lower their taxes by taking advantage of special provisions in the tax code to lower taxable income, take greater deductions, qualify for tax credits, and to invest tax-free or on a tax-deferred basis.

While you may not evade taxes (escape from paying taxes due), you have a right to avoid paying taxes by taking advantage of provisions in the tax code that give you a "tax advantage."

When asked, "What's the difference between tax evasion and tax avoidance?" a prominent jurist once replied, "10 to 15 years in federal prison."

What is a tax shelter? Here are the basics

Although it sounds like a specific place, a tax shelter is any investment strategy that enables you to legally decrease or avoid taxation.

Actual tax shelter investments sometimes require a large investment with a degree of risk. The goal of many shelters is to create offsetting losses to other taxable income.

Passive vs. active investing

In order to take advantage of tax sheltering, you will need to be able to differentiate between two types of taxable income. Passive activity income is derived from a trade or business activity in which you didn't "materially participate" during the tax year.

You are deemed to have "materially participated" by qualifying under one of seven IRS tests, each of which requires actual, substantial involvement in the business activity (for example, you spent at least 100 hours during the year in the activity, and nobody else spent any more time than you did.)

Generally, you can only deduct passive activity losses from passive activity income.

Real estate rental income is usually passive

In most common situations, income from real estate rental is an example of passive income. There is a special break, however, allowing a passive loss from rental real estate to be deducted from non-passive income, such as wages. This passive loss deduction is limited to $25,000, but is reduced by 50% of the amount of the taxpayer's adjusted gross income that exceeds $100,000.

Active income

Active income, on the other hand, is income from wages, tips, salaries, commissions, and a trade or business in which you materially participate.

So, what other methods can you use to legally reduce taxes? Here are some of the most common:

  • Lower your current taxable income. Placing your money in certain investments is one way to lower your taxable income.

  • Lower the tax rate of certain income. For example, hold onto an investment long enough to be taxed at long-term rather than short-term capital gains rates.

  • Increase your itemized deductions. Sometimes, you can combine deductions in one year to gain a higher benefit.

  • Defer income to years when you expect to be in a lower tax bracket.

Reading and filling the tax form
There are legal ways to avoid paying some taxes. (Photo: Getty Images)

The advantage of tax credits

Another way to reduce the amount of tax you pay is to receive a tax credit, usually by making an investment or purchase the law wishes to encourage — buying a hybrid car, for example.

A tax credit is a dollar-for-dollar reduction on the tax you owe. For example, a tax credit of $1,000 reduces the amount of tax you owe by $1,000. This is not the same as a tax deduction, which simply reduces taxable income.

The value of the deduction, therefore, depends on your tax bracket. In a 24 percent tax bracket, a $1,000 deduction reduces your taxes by only $240. Dollar for dollar, a tax credit is worth more than a tax deduction.

By legally reducing your tax liability, you have more capital available for spending or investing.

Tax-sheltered investments

Some investments provide tax advantages by either eliminating or postponing income tax on the investment income or growth. In what kinds of investments can you place your money to shield yourself from taxes? Here are some you might want to consider:

Tax-free municipal bonds

Interest earned from these government certificates of debt is usually free from federal income tax. Earnings from the sale of municipal bonds are subject to capital gains taxes.

Annuity contracts

An annuity is a series of guaranteed lifetime payments usually paid by an insurance company. Earnings from investor contributions to the annuity are immune from income taxes until the annuity is paid. Distributions from annuities prior to age 59½ may be subject to an additional 10 percent penalty tax. Annuity withdrawals will be taxed in the same year they are withdrawn.

Rental real estate

Property price appreciation is not subject to income tax each year. If the property is held longer than one year, any profit will be taxed at the long-term capital gains rate, which is usually lower than the taxpayer's ordinary income tax rate. Rental real estate can also offset income with losses and has the potential to earn tax credits in special situations.

Cash value life insurance (loans)

A portion of the premium payments is invested by the insurance company and builds the policy's cash value tax-deferred. This cash value can later be converted into a taxable withdrawal or borrowed, without tax consequence.

Tax credit investments

Certain investments, such as low-income housing and energy resources, may qualify for tax credits.

Another way to shelter your income is to invest in certain types of businesses that allow you to use their losses to offset your income. These include limited liability companies, partnerships, and certain trusts. These are sources of passive income, because the investor does not materially participate in their operations.

A limited partnership, for example, allows you to invest with limited liability and take the resulting profits or losses as part of your tax liability. However, deductions from passive activity losses are limited to the amount of net income passive activities generate.

Strategies to defer or reduce taxes

Tax-deferred retirement plans give investors the opportunity to defer taxes on investment earnings until retirement (usually age 59½).

Pre-tax earnings can be reinvested, greatly compounding the amount of interest you earn from your investments. Some of the most common types of tax-deferred retirement plans include the following:

401k plans

These plans give employees the ability to place a portion of their salary (up to $19,500 or 100 percent of their compensation for 2020) into a company-sponsored investment account. Taxes are deferred on earnings from the plan until they are withdrawn.

In addition, contributions to the plan are deducted from your ordinary income. Employees are given several options for investing the money into their 401k’s. Most 401k plans have matching employer contributions.

Keogh plans

Keogh plans are tax-deferred retirement plans for the self-employed and their employees. Contributions are deducted from ordinary income. The maximum annual contribution for 2020 is $57,000 or 100% of earned income, whichever is less.

In a Keogh plan, the self-employed individual controls which investments are bought and sold in the plan. Income earned from plan investments must be reinvested in the plan, and it grows tax-deferred.

Individual retirement accounts (IRAs)

Open to any gainfully employed person, IRAs are tax-deferred retirement plans that are directed by the employee. The maximum annual contribution for 2020 is $6,000 for an individual.

The non-working spouse of an IRA-eligible employee can also make a $6,000 contribution, if the couple's joint compensation is at least $12,000. IRA contributions may be fully or partially tax-deductible, depending on the taxpayer's (and/or spouse's) income and participation in an employer-sponsored, tax-favored retirement plan.

As with tax-qualified retirement plans, IRA investment earnings are tax-deferred until withdrawn at retirement. The amount of IRA contributions that may be deducted from personal income depends upon the taxpayer's income and whether the taxpayer (or spouse) is covered by an employee retirement plan at work.

Tax swapping

Another strategy investors use to shelter themselves from taxes is tax swapping. A tax swap consists of two parts. First, the investor sells a security that incurred a capital loss.

Second, the investor buys a similar security, which the investor believes to be a better investment, to replace it. By swapping securities, the investor offsets his or her portfolio gains with a loss while leaving the portfolio essentially unchanged.

Repurchasing the same security within 30 days of its sale is called a wash sale and eliminates any tax deductions from the security's capital loss.

Tax planning can be very much worth the effort, but a word of caution is in order: the proper use of any strategy can be more complex than it appears. You may want to consult a tax advisor before implementing any specific investment strategies to discuss their tax implications.

Summary of tax shelters

You can lower your taxes by reducing taxable income, taking deductions against taxable income, or using tax credits. There are many strategies and retirement plans available for the wise investor to keep his or her hard-earned money out of the hands of the tax collector.

Tax shelter plans can be quite complicated, so be sure to research them completely before selecting one for your investments.

The famed entertainer Arthur Godfrey is reported to have said: "I am proud to be paying taxes in the United States. The only thing is — I could be just as proud for half the money."

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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