Tax Shelters

What is Tax Shelters?

A tax shelter is a legal way of investing in certain plans or schemes that reduce the overall taxable income of the taxpayers and therefore save the taxes that are paid to the state or federal governments. For example, there are several retirement plans available for any individual to opt for that help reduce tax liabilities.

Types of Tax Shelters Investments

  1. Retirement plans, such as 401(k);
  2. Pension schemes
  3. Mutuality principle
  4. BondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.read more
  5. Mutual fundsMutual FundsA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks.read more
  6. Investing in real estate;
Tax Shelters

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Examples

  • Suppose you earn $500/day and decide to set aside 10% of your income in the 410(k) plan. Now, $50 will be kept aside per day as an investment in any of the tax shelters. The benefit of this plan is that you are required to pay tax on $450/day ($500-$50) and not on the entire sum of $500. The sum which will get deposited under plan 401(k) (for example) will not be chargeable to tax. Thus, you are not required to pay any tax on that amount, which is kept aside until we withdraw.
  • You work for a company, and that company offers you certain benefits such as medical allowances, house rent allowances, insurance for you and your family. All of these are also types of tax shelters since there will not be any tax levied over the amount involved in these benefits.
  • Owning a flat or a house can also be a tax shelter because you are relieved of paying tax on the year you purchase a property.
  • If you own a house worth $30,000 and additional floor worth $1,000 and you decide to sell the house after 5 years the buyer agrees to pay $75,000. After 5 years the index cost of acquisition of that house comes to $50,000. You are then required to pay tax on ($75,000 – $50,000) i.e. $25,000 and not on {$75,000 – ($30,000 + $1,000)} i.e. $44,000.

So these are some practical life-based tax shelter’s examples.

It is always a great deal to go for home equity since the capital gain tax exemption is $250,000 from the particular sale consideration.

Advantages

  • Easy to plan for a tax shelter investment
  • A good amount of sum can be contributed.
  • Helps to reduce taxable income
  • Easy withdrawal from such plans is possible.
  • Provides a platform for investment by which an individual can earn returns;
  • Taxes are either lowered or deferred.
  • Tax benefits can easily be derived.
  • On selling a house property, one can get an exemption of $250,000 on their sale consideration.

Disadvantages

  • The plans are generally not much flexible.
  • There are chances of penalties in case of early disbursement of the money kept aside.
  • Additional taxes can also be levied in some cases.
  • Some tax shelter methods or schemes are very risky.
  • Returns are assured, but in some cases, the rate of tax levied on that sum can be higher than the returns expected hence making it a very unpredictable investment.
  • Inflation also plays a very vital role. Due to adverse changes in the economic condition of the country, the entire planning can be ruined.

Limitation

Conclusion

Tax laws and Government policies provide us with many platforms to save taxes in legal ways. Some retirement policies like 401(k) help us save money as well as the tax on our earned incomeEarned IncomeEarned income is any amount earned by an individual, such as a salary, wages, or employee compensation. It can also be an individual's income through their own business.read more. Thus by keeping aside some small amount from our earnings, we can save and build a corpus for the future. Some critics say that tax shelters are negative. The concept should be well understood by all those who want to retain and grow their hard-earned money and to get tax benefits or deduction in tax or maybe a considerable relaxation on withdrawal.

Recommended Articles

This has been a guide to what is Tax Shelters and its Definition. Here we discuss the types of tax shelters investments along with Examples, advantages, and disadvantages. You can learn more about accounting from the following articles –

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