TAX SHELTERS HAVE gotten a bad rap. Some are illegal, such as offshore companies and bank accounts that aim to hide income and profit from the government to avoid tax. But there are plenty of havens for law-abiding citizens that cut taxes.
A tax shelter is simply a way to reduce your taxable income, so you pay less tax, no matter how much or how little money you make. Here are five legal ways for just about everyone to minimize taxes and save more money.
Make contributions to retirement accounts. One of the best ways to protect your income from taxes and accumulate wealth for the future is to contribute to one or more retirement accounts.
There are accounts designed for individuals, such as an individual retirement account, commonly called an IRA, and those offered only in the workplace, such as a 401(k) or 403(b). And if you're self-employed (either full- or part-time), you have options too, such as a solo 401(k) or a SEP-IRA.
Different retirement accounts come with different rules and annual contribution limits. But the main benefit you receive from a traditional account, such as a traditional IRA or 401(k), is an upfront tax deduction. You skip paying tax on traditional contributions and earnings in the account until funds are withdrawn.
The other main type of retirement account, a Roth, requires income tax on contributions but allows withdrawals in retirement that are completely tax-free. You can participate in a Roth at work no matter how much you earn, but there are annual income thresholds to contribute to a Roth IRA.
Get workplace benefits. If you work for a company that offers benefits, such as health and disability insurance, the cost to you is typically deducted from your paycheck before taxes. That's income you skip paying tax on.
Also, if your employer reimburses you for substantiated expenses such as education or a car allowance, that's also nontaxable income.
Use medical savings accounts. Some employers offer special accounts, such as a flexible spending account, commonly called an FSA, or a health savings account, called an HSA, to help workers manage their health care expenses. You and your employer can make contributions that are tax-free, as long as the funds are spent on qualified medical expenses.
There are a few rules to follow, including spending the balance of an FSA by an annual deadline. Anyone who has a qualified high-deductible health plan, purchased through an employer or on your own, is eligible for an HSA. Unused funds in an HSA roll over from year to year and can even be used like a retirement account after age 65. Both accounts are smart vehicles to shelter a wide variety of unreimbursed medical expenses from taxes.
Be a homeowner. Real estate is a real shelter and a powerful tax shelter, too. Owning property cuts your taxes the year you purchase it, every year you own it and even on the back end when you sell it.
Mortgage interest and property taxes are typical tax deductions for homeowners. If you tap your home's equity with a loan or a line of credit, you may also be able to deduct some of the interest you pay on that debt, too. However, the new tax law almost doubled the standard deduction, which makes itemizing deductions, such as mortgage interest and state taxes, less likely for many taxpayers.
If you decide to sell your main home and lived there for at least two of the five years preceding the sale, you avoid paying tax on up to $250,000 of capital gains on the sale. If you're married and file a joint tax return, double that amount for an impressive $500,000 you get to keep tax free.
Start a business. Whether you want to be a full-time entrepreneur or just earn a little extra income on the side, having a business is another way to shelter more of your money from taxes.
If you're attempting to make a profit from your business, you can turn some of your personal expenses into allowable business deductions. For example, a computer, accounting software and a phone are likely necessary and reasonable expenses to run your venture.
If you operate your business from a home office (in a home you own or rent), you're allowed to deduct a certain amount of household expenses, such as maintenance, insurance and utilities, based on the size of your office as a percentage of your home, using either a standard or a simplified calculation method.
These five tax shelters – retirement accounts, workplace benefits, medical savings accounts, real estate and businesses – are common instruments through which to pay fewer taxes. With all these legal options, who needs an offshore account?