What is Tax Sheltering?

Dale Marshall

Tax sheltering is the practice of making investments and purchases for the purpose of benefiting from preferential tax treatment. There are three different types of tax shelter in the United States: those on which no tax is ever due, or tax-exempt; those on which tax liability is postponed or deferred, usually until the money is withdrawn by the taxpayer; and those which reduce the taxpayer’s tax liability without regard to income at all, or tax credit.

Tax liability on 401(k) plans is deferred until money is drawn out.
Tax liability on 401(k) plans is deferred until money is drawn out.

In the United States, one of the most popular tax shelters is home ownership, which not only exempts the interest payments made toward home mortgages from income taxation, but also exempts from income taxation the first $250,000 US Dollars (USD) — or $500,000 USD in the case of married couples filing jointly — of gain from the sale of a primary personal residence. Other popular tax shelters in the United States, on which taxes are more often deferred than exempted, are retirement savings programs.

Home mortgage interest is one of the most well-known tax shelters.
Home mortgage interest is one of the most well-known tax shelters.

A very popular tax sheltering opportunity used by many employed taxpayers is a flexible spending account (FSA), which gives them the option of setting aside a portion of their compensation on a tax-free basis. Money contributed to a medical FSA can be used only for the payment of medical costs not covered by health insurance, such as deductibles and co-insurance; funds contributed to a Dependent Care FSA can be used only for the payment of dependent care expenses. Income contributed to FSAs is completely tax-free.

Charitable contributions — that is, contributions of cash or items of value to charity — are a popular tax sheltering tool. They provide a straight deduction; for every dollar contributed, a dollar is deducted from the taxpayer’s taxable income. This particular tax shelter is sometimes abused because some taxpayers overstate the value of items contributed. Less popular tax shelters are deductions based on business or investment losses.

There are a number of tax sheltering strategies that can be employed in retirement planning. Employer-sponsored plans, such as 401(k) and 403(b) plans, defer income tax liability on all funds contributed and the interest they earn until drawn out by the taxpayer. Contributions are made from the taxpayer’s compensation before taxes are withheld, so there’s no requirement to use them as deductions on the income tax return. Individual Retirement Accounts (IRAs) are tax-deferred retirement savings accounts usually established and maintained by taxpayers individually, with no need for employer sponsorship. The money deposited to them is deducted from the taxpayer’s income on the annual tax return, and the interest they earn is tax-free when earned, but all funds withdrawn from an IRA during retirement are subject to income taxation at the taxpayers current tax rate. A Roth IRA, on the other hand, is funded entirely with post-tax funds, but the interest they earn is totally tax-free.

Annuities, the interest on which are tax-deferred, are another popular tax sheltering technique. Taxpayers who purchase annuities aren’t limited by annual caps on their contributions, such as are imposed on IRAs, and they also aren’t required to report, or pay tax on, any of the interest earned by the annuity until the money is actually drawn out. Since most annuities last at least seven years, and often many more, the compounding of the interest earned grows much more than if taxes were due annually on the earnings, as they are with most bank savings accounts and certificates of deposit (CDs).

Tax credits are less common than deductions and deferrals, and in some cases, aren’t the product of tax sheltering strategies. Some tax credits are refundable; that is, if their application reduces a taxpayer’s liability to below zero, the amount of the negative tax liability is paid over to the taxpayer. Other credits are non-refundable, which means that if they reduce the taxpayers liability below zero, the liability is simply adjusted to zero. Parents whose income is below a particular threshold, for instance, are entitled to a refundable income tax credit of $1,000 USD for every child under age 17. Tax credits are also available to low-income taxpayers, the elderly, and the disabled. In addition, tax credits are available for certain education expenses, to home buyers, and to those who purchase certain items that are certified as promoting or enhancing energy efficiency.

Tax credits are available to low-income taxpayers, the elderly and the disabled.
Tax credits are available to low-income taxpayers, the elderly and the disabled.

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