What is Tax Shelters?

Types of Tax Shelters Investments

  • Retirement plans, such as 401(k);Pension schemesMutuality principleBondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read moreMutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etcread moreInvesting in real estate;

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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 daily as an investment in any tax shelters. The benefit of this plan is that you must 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 that offers you certain benefits such as medical allowances, house rent allowances, and insurance for you and your family. These are also types of tax shelters since no tax will be 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 examples.

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

  • The government has allowed some standard deductions for the taxpayersTaxpayersA taxpayer is a person or a corporation who has to pay tax to the government based on their income, and in the technical sense, they are liable for, or subject to or obligated to pay tax to the government based on the country’s tax laws.read more that are also a kind of tax shelter. The standard deduction for the individual comes to$12,000, and for married couples, those filing returns together get a standard deduction of $24,000. So if a family of husband and wife earns $70,000 and $30,000 respectively they are liable to pay tax only on {$100,000 – (2x$12,000)} or $76,000 rather than on the entire family income i.e. ($70,000 + $30,000) or $100,000.

Advantages

  • Easy to plan for a tax shelter investmentA good amount of the sum can be contributed.Helps to reduce taxable incomeEasy 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 benefitsTax BenefitsTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place.read more 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 very 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 tax rate levied on that sum can be higher than the expected returns, making it a very unpredictable investment.Inflation also plays a very vital role. Due to adverse changes in the country’s economic condition, the entire planning can be ruined.

Limitation

  • It is not independent.One of the tax shelters is to invest in real estate, but in reality, each real estate is a separate entity on its own. The ready to use real estate property has two phases under construction, and the other one is the developed phase. Both the phases are separate, and the tax treatment will be different when it is sold or leaseLeaseLeasing is an arrangement in which the asset’s right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.”read more.Some tax shelters are not exempted from tax, especially the cash-based transactions in which withdrawal happens.Risk is not hedged here.

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.

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 –

  • Tax Avoidance MeaningNanny TaxTax Lien