# Tax Shelter: Definition, Examples, and Legal Issues

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## What Is a Tax Shelter?

A tax shelter is a vehicle used by an individual or organization to decrease their taxable income and, therefore, their [tax liabilities](https://www.investopedia.com/terms/t/taxliability.asp). It can be used legally or illegally. Legal tax shelters range from investment accounts that provide favorable tax treatment to activities that lower taxable income through deductions or credits. Illegal tax shelters are used for tax evasion.

### Key Takeaways

*   A tax shelter is a place to store assets so that current or future tax liabilities are minimized.
*   A tax shelter can be used legally or illegally.
*   Tax shelters may permanently reduce the amount of tax a taxpayer owes or may simply defer the taxes owed to a future period.
*   Qualified retirement accounts, certain insurance products, partnerships, municipal bonds, and real estate investments are all examples of potential tax shelters.

## Understanding Tax Shelters

There are numerous tax shelters that the government has provided to help taxpayers lower their tax burden. [Tax deductions](https://www.investopedia.com/terms/t/tax-deduction.asp), for one, are amounts of income that can be deducted from an individual’s taxable income. The tax rate that is applied to the lower taxable income will translate into a lower tax bill for the individual. Some tax shelters that are provided in the form of tax deductions include a deduction of charitable contributions, [student loan interest deduction](https://www.investopedia.com/terms/s/slid.asp), mortgage interest deduction, deduction for certain medical expenses, etc.

For example, the Internal Revenue Service (IRS) allows charitable donations to be tax-deductible for up to 50% of an individual’s [adjusted gross income (AGI)](https://www.investopedia.com/terms/a/agi.asp). Donating to a qualified charity generally reduces your taxable income. For instance, if you donate $12,000 to a charity and you're in the 22% tax bracket, your taxable income would drop by that amount. This means you could lower your tax bill by 22% of the donation, or about $2,640.

## Types of Tax Shelters

### Retirement Accounts

Tax shelters are legally available in the form of investment and [retirement accounts](https://www.investopedia.com/articles/retirement/08/best-plan.asp) that shelter income from taxes. The tax shelter provided through these accounts serves as an incentive to save for retirement. Contributions made to a traditional (non-Roth) [401(k)](https://www.investopedia.com/terms/1/401kplan.asp), [403(b)](https://www.investopedia.com/terms/1/403bplan.asp), or [individual retirement account (IRA)](https://www.investopedia.com/terms/i/ira.asp) will not be taxable until retirement. This way, money that would have been taxed by the IRS accrues interest and earnings in the account until the funds are withdrawn, ideally when the taxpayer is in a lower tax bracket.

A taxpayer who takes advantage of the tax shelter provided through a 401(k), 403(b), or IRA reduces their taxable income by the amount of their contribution.

For individuals who expect to be in a higher income tax bracket by the time they retire, the [Roth IRA](https://www.investopedia.com/terms/r/rothira.asp) and [Roth 401(k)](https://www.investopedia.com/terms/r/roth401k.asp) provide a way to shelter income from higher taxes. With a Roth account, the contributed income is taxed before entering the account. Then there are no taxes in retirement when the funds are withdrawn, as long as the account has been open for at least five years.

> **Tip**
>
> When choosing between a Roth or traditional retirement account, consider whether you should pay taxes now or later. It may be better to pay taxes today (with a Roth account) to make sure those investments can be withdrawn tax-free.

### Foreign Investments

Investors with [foreign investments](https://www.investopedia.com/terms/f/foreign-investment.asp) in their portfolios can take advantage of the [foreign tax credit](https://www.investopedia.com/terms/f/foreign-tax-credit.asp) which applies to taxpayers who pay tax on their foreign investment income to a foreign government. The credit can be used by individuals, estates, or trusts to reduce their [income tax](https://www.investopedia.com/terms/i/incometax.asp) liability.

### Oil and Energy

To encourage investment in companies of certain sectors (oil exploration, renewable energy, and mining, for example) which require heavy [capital investment](https://www.investopedia.com/terms/c/capital-investment.asp) and take several years to start making profits, the government allows the exploration costs incurred by these companies to be distributed to shareholders as tax deductions. The [exploration and development costs](https://www.investopedia.com/terms/e/exploration-production-company.asp) are taken as the shareholders’ expenses; shareholders deduct the expenses from their taxable income as if they directly incurred these costs.

### Municipal Bonds

Some [municipal bonds](https://www.investopedia.com/terms/m/municipalbond.asp) are tax-exempt, meaning that any interest income that is generated is free from the obligation of [federal income taxes](https://www.investopedia.com/terms/f/federal_income_tax.asp). And in many cases, it's exempt from state and local income taxes as well. Note that interest income from municipal bonds is generally not subject to the [Alternative Minimum Tax (AMT)](https://www.investopedia.com/terms/a/alternativeminimumtax.asp).

### Mutual Funds

[Mutual funds](https://www.investopedia.com/terms/m/mutualfund.asp) that invest in government or [municipal bonds](https://www.investopedia.com/terms/m/municipalbond.asp) are also common tax shelters. Though you still pay income tax on your initial investment when those dollars are earned, the interest generated by these [debt securities](https://www.investopedia.com/terms/d/debtsecurity.asp) is exempt from [federal income taxes](https://www.investopedia.com/terms/f/federal_income_tax.asp), so your investment generates annual income tax-free.

### Real Estate

Physical [real estate](https://www.investopedia.com/terms/r/realestate.asp) in addition to [real estate investment trust (REIT)](https://www.investopedia.com/terms/r/reit.asp) vehicles may be used as a tax shelter. Taxpayers may receive favorable treatment due to [depreciation](https://www.investopedia.com/terms/d/depreciation.asp) deductions. Taxpayers may also receive benefits by performing [1031 like-kind exchanges](https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx) that allow for the sale of a property and avoidance of [capital gains](https://www.investopedia.com/terms/c/capitalgain.asp) of the proceeds. Landlords and real estate investors may also be able to deduct rental losses from their rental income, thereby reducing their taxable income.

### Conservation Easements

In some cases, agreements between landowners and a conservation organization can result in a tax benefit. These easements often reduce the use of land in order to protect a natural resource. When a taxpayer donates a conservation easement, they may be able to claim a tax deduction based on the value of the easement.

## Tax Shelter Strategies

There are two primary tax sheltering strategies.

The first is trying to [minimize tax liability](https://www.investopedia.com/articles/managing-wealth/071116/captive-insurance-legitimate-tax-shelter.asp). This is done most often by minimizing taxable income by offsetting taxable income against taxable losses or by simply reducing taxable income. For tax avoidance strategies, the goal is to never pay that tax and avoid taxes altogether.

The second is tax deferral. Consider popular retirement accounts such as a [traditional IRA](https://www.investopedia.com/terms/t/traditionalira.asp). The [gains](https://www.investopedia.com/terms/g/gain.asp) for a traditional IRA are taxable when withdrawn. That is, those taxes are deferred to the future. Therefore, a taxpayer can plan for the future and not worry about immediate tax implications.

> **Important**
>
> The IRS tax code changes every year. It is critical you consult your tax advisor when considering tax shelter strategies, as your assumptions from one year may no longer be valid in the next.

## Tax Shelter vs. Tax Evasion

While tax shelters provide a legal way to avoid taxes, they can also be used illegally, to evade taxes. Tax minimization (also referred to as [tax avoidance](https://www.investopedia.com/terms/t/tax_avoidance.asp)) is a perfectly legal way to minimize taxable income and lower taxes payable. Do not confuse this with [tax evasion](https://www.investopedia.com/terms/t/taxevasion.asp), the illegal avoidance of taxes through misrepresentation or similar means.

If an investment is made for the sole purpose of avoiding or evading taxes, you could be forced to pay additional taxes and penalties.

Companies that create offshore companies for the purpose of evading taxes will be heavily penalized by the IRS. Such activity is subject to steep fees and criminal prosecution.

## Tax Shelter vs. Tax Haven

A [tax haven](https://www.investopedia.com/terms/t/taxhaven.asp) is a country or jurisdiction that offers low tax rates. A tax haven may also offer taxpayers minimal or no tax reporting requirements alongside strong financial privacy laws.

Individuals and businesses use tax havens to avoid or evade taxes. Though tax shelters may accomplish some of the same outcomes as a tax haven, tax havens are often coupled with a lack of transparency and secrecy.

## What Are the Best Ways to Shelter Money From Taxes?

The best way to shelter money from taxes is to seek deductions, credits, or tax-favorable investment vehicles. These strategies may either reduce your taxable income (and resulting tax liability) or defer taxes to a future period, ideally when you're in a lower tax bracket. Most often, investors can leverage their company's 401(k) plan to generate investment earnings with tax deferred (or, in the case of a Roth account, tax-free) growth.

## Is an LLC a Tax Shelter?

An LLC may be a tax shelter, depending on prevailing tax brackets. The taxable income of an LLC may be assessed at a rate as high as 21%. Should a sole proprietor earning the same revenue be taxed at their individual marginal tax rate, they may pay a substantially more in taxes.

## How Do Wealthy Individuals Avoid Taxes?

Wealthy people avoid taxes in a few different ways. First, they often strive to minimize their net taxable income each year. This includes offsetting gains with losses, and this means avoiding large [capital gains taxes](https://www.investopedia.com/terms/c/capital_gains_tax.asp) for the disposal of assets. In some cases, wealthy individuals may take out loans with personal property as collateral to meet cashflow needs while not generating taxable income.

## The Bottom Line

A tax shelter is a strategy or investment vehicle that is designed to reduce or defer tax liabilities. Tax shelters can be used by individuals, businesses, or organizations. Legal tax shelters take advantage of deductions, credits, or other incentives provided by the tax code, whereas illegal tax shelters are used for tax evasion.

> **Article Sources**
>
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>     
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