Using a tax shelter might not seem like something you want to do. After all, the term often brings to mind visions of wealthy people and businesses tucking away money in shady offshore accounts to avoid paying taxes.
“The connotation is of something abusive and fraudulent,” says Logan Allec, a CPA with Choice Tax Relief in Los Angeles. That reputation may have something to do with the fact that the IRS Office of Tax Shelter Analysis is devoted to uncovering unscrupulous ways people try to get out of paying their share into government coffers.
However, there are a number of perfectly legal and respectable ways to shelter money from taxes. These include tax-deferred savings, savvy investments and even your home.
“Tax avoidance is different than tax evasion,” notes Paul Murray, founder and president of PTM Wealth Management in North Wales, Pennsylvania.
Keep reading for everything you need to know about tax shelters and six options that could work for you.
What Is a Tax Shelter?
Depending on whom you ask, a tax shelter can be defined in different ways. Broadly speaking, though, it can be anything used to minimize a person’s income tax liability.
That means tax shelters can include strategies for deducting expenses to lower your adjusted gross income or paying for workplace benefits with pretax dollars. Regardless of the method, the goal is to legally lower taxes on income and assets.
“I want my clients to pay every penny they owe in taxes and not a penny more,” explains Shanna Tingom, financial planner and co-owner of Heritage Financial Strategies in Gilbert, Arizona. Tax shelters such as tax-advantaged savings accounts help her achieve that result for her clients.
[READ:Ways to Save Money on Your Taxes This Year]
What to Know About Tax Shelter Risks
Tax shelters come with risks. Some complex investments can skirt the law, and it can be easy to fall victim to a scam if you don’t properly research a proposed strategy.
Captive insurance companies are one example. These companies, which are owned by the person insured, allow a person to deduct premiums paid, and then, assuming no claims are made, those premiums may eventually be refunded. While this strategy can be used legally, some businesses have set up captive insurance companies offering coverage of dubious value and then deducting exorbitant premiums, and the IRS has started cracking down on them.
Even if you follow the letter of the law, some complex tax shelters could make your life more difficult if they include reportable transactions that require the submission of Form 8886, the reportable transaction disclosure statement. Including it with your tax return could significantly increase your chances of an audit.
Other tax shelters are less risky, but they still have drawbacks. For instance, tax-deferred accounts for retirement or health savings may limit your access to the cash. If you withdraw money too quickly from a retirement account or spend money from a health savings account on a non-medical expense, you could get hit with a tax penalty.
“If you don’t do them correctly, there can be some unintended consequences,” Tingom says. What’s more, people need to be careful not to rely on old advice. “Tax laws change all the time,” she says.
6 Legal Tax Shelters to Consider
If you are looking for a way to reduce your taxes legally, here are six tax shelters that may be available to you:
— Retirement accounts
— Workplace benefits
— Medical savings accounts
— Real estate
— Business ownership
— Certain investments
Retirement Accounts
Almost anyone can open a tax-favored retirement account, making it a good place to start for minimizing taxes.
Traditional IRAs, 401(k)s and similar retirement savings vehicles allow people to deduct their contributions. In 2022, employees can make up to $20,500 in deductible contributions to a 401(k) with workers age 50 and older entitled to deduct an additional $6,500 in catch-up contributions. Deductible IRA contributions are limited to $6,000 for workers younger than 50 and $7,000 for those age 50 and older.
“A lot of 401(k)s are implementing an after-tax bucket,” Tingom says. This option allows people to fund their 401(k) account with after-tax dollars. It may not sound like a tax shelter, but she says it paves the way for high earners to transfer money to a Roth retirement account.
With traditional retirement accounts, taxpayers get an upfront tax deduction and then pay income tax on withdrawals in retirement. Roth accounts, on the other hand, are funded with after-tax dollars in exchange for tax-free retirement withdrawals. There are income limitations on who can contribute to a Roth account, but it’s currently legal for almost anyone to make traditional or after-tax 401(k) contributions using earned income and then convert the balance to a Roth account.
“Taxes have never been lower in the history of the country,” Murray says. And the tax cuts enacted by the Tax Cuts and Jobs Act of 2017 are set to expire in 2025, making now a good time to contribute or convert funds to a Roth account. That way, Murray says, you avoid paying taxes in the future when rates could be higher.
Workplace Benefits
Workers who buy group insurance coverage through their employer may be able to pay premiums with pretax dollars. These benefits typically include coverages such as life, disability, vision, dental and health insurance. Paying for these with pretax dollars has the effect of lowering your taxable income.
Prior to the Tax Cuts and Jobs Act, workers could also deduct unreimbursed expenses such as mileage. Since the tax reform eliminated that deduction for everyone but the self-employed, workers may want to negotiate reimbursements for these expenses instead. Any workplace reimbursement has the added benefit of not being taxable.
Jim Harbaugh, head coach of the University of Michigan football team, is a prime example of someone who leveraged workplace benefits as a tax shelter, Murray says. His 2016 contract included $14 million in life insurance which he can borrow against for tax-free income during his lifetime.
“It’s a phenomenal tax advantage strategy to use,” says Mark Charnet, wealth management specialist and CEO of American Prosperity Group in Pompton Plains, New Jersey. Overfunded life insurance is one example of non-qualified deferred compensation that workers can negotiate to lower their taxable income.
If you have children, don’t overlook the option to use a dependent care flexible spending account, or DCFSA, to pay for child care costs. Many employers offer these accounts, which allow parents to deposit up to $5,000 in pretax dollars each year to be used for expenses such as child care, summer day care, before- and after-school care and nannies.
However, be aware that expenses paid for with a DCFSA are not eligible for a child and dependent care tax credit. Take note that money deposited into a flexible spending account typically must be used that same year or be forfeited.
[READ:What Is a Tax Haven?]
Medical Savings Accounts
Flexible spending accounts and health savings accounts are two ways to shield money spent on health care from taxes.
“If you have an HSA-eligible health insurance plan and you are not contributing to an HSA, you’re missing a huge opportunity,” Tingom says. Money deposited into HSAs is tax deductible, the money grows tax deferred and withdrawals are tax-free when used for qualified medical expenses.
In 2022, those with family insurance plans can contribute up to $7,300 to an HSA and deduct that amount from their taxes. Single policyholders can contribute and deduct up to $3,650. In either case, workers age 55 and older can deposit an additional $1,000 in catch-up contributions.
You’ll need an eligible high-deductible health insurance plan to contribute to an HSA. If you don’t have one, your employer may offer flexible spending accounts, or FSAs, for all workers. These accounts work similar to the DCFSA, but the balance of an HSA will roll over year to year.
Real Estate
Buying property — either for personal use or as an investment — is another way to reduce taxes.
Mortgage interest and property taxes can be deducted by those who itemize deductions on their federal tax returns. What’s more, property typically appreciates, or gains value, each year, and money from a home sale could end up being tax free.
When you sell your home, so long as you have lived at the property for two of the past five years, you can exempt up to $500,000 of the appreciated value from capital gains tax. Even if your home doesn’t qualify for the capital gains exemption, you could come out ahead. “Capital gains rates are infinitely less than income tax,” Charnet explains.
Rental real estate can also provide tax benefits, but there are specific rules about who can take deductions for rental properties and how they are calculated. Some savvy investors use rental properties to obtain tax-free money by borrowing against equity in addition to writing off the depreciation on their tax forms.
If you’d like to invest in real estate to lower your tax liability, talk to a financial professional for guidance since the rules can be complex.
Business Ownership
Since the Tax Cuts and Jobs Act significantly reduced the number of deductions available to employees, business ownership has become a more attractive option to some people.
“It’s a great way to kickstart tax savings,” Tingom says.
Self-employed workers and small business owners can deduct a variety of expenses such as internet and wireless service, computer software and office supplies. Those who work from home and are self-employed may also be able to deduct expenses related to a home office.
Taxpayers can also hire their children as employees — a strategy that’s a bit more advanced.
“Pay them up to the standard deduction amount, and it could be a write-off,” Allec says. Even better, have the children put their income into a Roth IRA so they money will turn into tax-free income for them in the future.
If you go this route, be sure to pay a reasonable wage and only for work that you would realistically hire someone else to complete. “If you’re paying them $100 an hour to file papers, that’s probably stretching it,” Allec says. And that could cause problems during an audit.
[See: Red Flags That Could Trigger a Tax Audit.]
Certain Investments
Tax-sheltered investments have the potential to provide the greatest savings, but they also come with the highest risk.
Captive insurance is one example of a popular option that has come under increased scrutiny from the IRS, as have syndicated conservation easements. You should be wary of anyone offering investment returns that sound too good to be true. Get a second opinion if you aren’t sure about the investment’s legitimacy or the credibility of the person trying to sell it to you.
Safer alternatives to minimize taxes include tax-deferred annuities and municipal bonds. The returns on bonds are often modest, but the gains may be exempt from both state and federal taxes.
Charnet also suggests investing in items such as antiques, baseball cards, art and luxury watches as tax shelters. “Anything collectible that would not create a 1099 (tax form) when sold,” he says.
However, as with all investment, do your homework first since there are no guarantees about if and how these items will appreciate in value over time.
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6 Legal Tax Shelters to Consider originally appeared on usnews.com
Update 03/22/22: This story was published at an earlier date and has been updated with new information.
