These legitimate tax shelters may help you reduce the amount you owe to Uncle Sam.
The term “tax shelter” often carries a negative connotation. Perhaps it’s due to the wealthy using anonymous Swiss bank accounts and the like to evade taxes.
But legitimate tax shelters do exist, and they could help you legally reduce the amount of tax you owe each year. Here are seven to consider:
1. Retirement Accounts
One way to reduce your tax liability is to invest in a tax-advantaged retirement account, such as a 401(k) or individual retirement account. Choose among three different options:
401(k) Retirement Accounts
Americans can contribute up to $22,500 pretax into their 401(k) retirement accounts in 2023. When you make contributions, employers subtract them from the your taxable income, which lowers your tax liability for the year.
You have to pay taxes when you withdraw funds from a 401(k) account in retirement but you may be in a lower tax bracket at that point.
In 2023, you can contribute up to $6,500 to IRAs ($7,500 if you’re 50 or older), as long as you earn at least that amount in taxable income for the year. If you earn less, your limit will be equal to the amount you earn.
When tax time rolls around, you may be able to deduct the amount you contributed throughout the year. Contributions, however, are limited if you or your spouse are covered by a retirement plan at work and your income exceeds certain levels.
Roth IRAs
While Roth IRAs don’t offer tax benefits on the front end, they can shelter you from taxes down the road. These accounts require you to make contributions with post-tax dollars – then, qualified withdrawals of your contributions and earnings are tax-free in retirement.
“A Roth IRA is a tax-efficient retirement saving tool that allows you to pay taxes on your savings now instead of later, grows your money tax-free and gives you more control over when you use your money in retirement,” says Brian Levy, founder and president of BML Wealth Management
While income limits restrict who can directly invest in a Roth IRA, backdoor Roth IRAs provide a workaround for those whose incomes exceed the limits.
2. Charitable Contributions
You can also reduce your tax liability by making charitable donations of cash or other property to qualified organizations. In most cases, you can deduct up to 50% of your adjusted gross income worth of donations, although you can deduct only up to 30% when donating to certain organization types.
3. Medical and Dental Expenses
The money you spend on medical and dental expenses can also be tax-free.
If you have an employer-sponsored health insurance plan, premiums will be deducted from your paychecks on a pretax basis. Additionally, employers may offer tax-advantaged flexible spending accounts for out-of-pocket health care costs.
You and your employer can contribute pretax dollars to an FSA. Then, when you incur an out-of-pocket medical expense, you submit a claim and it gets reimbursed from your account. In 2023, you can contribute up to $3,050 to FSAs, per employer.
If you have a high deductible health plan, you can make contributions to a health savings account. When HSA contributions are made by you or anyone aside from your employer, they are deductible. Employers can also make contributions on your behalf but that will reduce your taxable income.
In 2023, you can contribute up to $3,850 if you have an HSA and up to $7,750 if you have HDHP coverage for your family. You can then take distributions from an HSA tax-free if you spend them on qualified medical expenses.
4. Real Estate
Have you considered investing in real estate? It could help you save on taxes in a few ways.
If you buy a home using a mortgage, you can deduct the portion of your payment that’s attributable to interest and property taxes.
If you decide to sell, up to $250,000 (or $500,000 for married couples) could be exempt from capital gains taxes – as long as you lived in the home for two of the past five years.
On the other hand, if you buy an income-producing rental property, you may be able to deduct the depreciation of the property each year for 27.5 years.
Additionally, if you sell an investment property and reinvest the funds in another one within certain time limits, the taxes on the sale may be eligible for deferment.
5. Business Deductions
Owning a business comes with additional tax responsibilities but can also offer tax benefits.
Business owners are able to take tax deductions for a variety of expenses that are considered ordinary and necessary in their industries. For example, you may be able to write off a home office, business vehicle, travel expenses and paying your children to work in your company.
Business startup costs, improvements and business assets, however, are not treated like other expenses. They are considered capital expenses that you can recover over time through depletion, amortization or depreciation.
“Small businesses are often not aware that any expenses that are incurred before the first sale are called startup costs. These costs cannot be deducted until the first sale. Then, they are deducted over 15 years, and you can elect to deduct the first $5,000 in the first year of business,” Gail Rosen, certified public accountant at Gail Rosen, CPA, says.
6. 529 Plans
Qualified tuition plans, also known as 529 plans, are programs that allow you to prepay a beneficiary’s qualified higher education expenses or contribute to an account that will be used to pay for them.
While contributions must be made with post-tax dollars, earnings from the account aren’t subject to federal tax when they’re used for college expenses. They’re usually exempt from state tax, too.
“529 plans are commonly invested in a mixture of mutual funds or ETFs (exchange-traded funds) and grow tax-free, so you don’t pay taxes each year on the capital gains or dividends within the account,” says Jim Kirk, chartered financial consultant and owner of Rocky Mountain Financial Solutions.
The amount you can contribute is limited by the qualified expenses of your beneficiary, and potentially the gift tax limits and limits set by your state.
“The ideal situation is to open an account when the beneficiary (your child in most cases) is born, which will allow approximately 17 to 19 years of account contributions and growth within the account to maximize before needing the funds for higher education,” Kirk says.
7. Capital losses
When you sell a capital asset that’s not a piece of personal-use property and you get less than your adjusted basis in the item, the loss is deductible.
For example, if you buy a stock and sell it for less than the buying price, that would qualify as a deductible capital loss. In 2023, you can deduct the lesser of your total net loss or $3,000 on your taxes – or $1,500 if you are married and filing separately.
While taxes are a part of life, there are many programs and laws that help reduce the amount you end up owing. If you want to ensure you don’t pay more than you need to and that all of your deductions are legal, it might be beneficial to consult a tax counselor or certified financial advisor.
