Tax shelters have a reputation for being something only mildly scuzzy rich people would use. In truth, nearly everyone has benefited from a tax shelter at some point in their lives. A tax shelter is nothing more than a way to protect some of your money from taxation -- or at least delay the tax until later.
The IRS is careful to distinguish between tax shelters and what it calls abusive tax shelters. Regular tax shelters are perfectly legal and legitimate, while the ones that break the rules are classed as abusive tax shelters and are illegal. None of the following tax shelters is abusive, so you can use any of them with the IRS's blessing.
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Tax-deferred retirement accounts
That's right, your 401(k) account qualifies as a tax shelter. Remember, the definition of a tax shelter is that it protects your money from taxes -- and 401(k)s and other tax-deferred accounts do just that: They allow you to stash your income away without having to pay taxes on it, even if you make transactions within the account that would normally be taxed, like selling stocks at a gain.
Eventually, when you take the money back out, you will need to pay taxes on it. However, since you can plan your distributions to minimize the tax impact, these accounts can save you a ton of money. For example, you can limit your 401(k) distribution for the year so as to stay in a low tax bracket, taking the rest of the income you need from nontaxable sources such as Roth IRAs or Roth 401(k)s.
College savings plans
529 savings plans allow you to stash money in the account, let that money grow for years or even decades, then pull it out at the end to spend on your child's educational expenses -- tax-free. If you choose a low-fee plan, this could work out to be an even better tax deal than a tax-deferred retirement account. The only catch is that these funds may negatively affect your child's eligibility for financial aid, because lenders consider the money in a 529 plan to belong to your child, affecting their calculations for their financial need.
Municipal bonds
The IRS doesn't tax income from municipal bonds. Depending on which state you live in and whose bonds you buy, they may be exempt from state income tax as well. The catch is that the bondholders are well aware of this tax advantage, and they take it into consideration when deciding how much of a return to offer on the bond. As a result, it's important to compare the return from the municipal bond you're thinking of buying to similar taxable bonds to be sure that you really are saving enough on taxes to make it worthwhile.
Real estate
Buying a house can provide you with incredible tax benefits, both now and in the future. In the short term, homeowners get to deduct mortgage interest and real estate taxes from their federally taxable income. That means the money you spend on those expenses is not taxable. When the time comes for you to sell the house, you could easily qualify for the home sale tax exclusion, meaning the gain you make on the sale is also not taxable.
Investment real estate also makes a fine tax shelter: You get the same deductions for mortgage interest and property taxes as you do for your personal residence (and as a bonus, you don't even have to itemize deductions to claim these tax breaks for rental properties). You can also deduct pretty much every expense related to the property, from repairs to utilities to the cost of advertising your rental. And even though you'd probably buy investment real estate with a loan, only putting down a small fraction of the cost in your own money, you can immediately depreciate the building based on its full value at the time of purchase (depreciation means you can deduct a percentage of the building's cost each year until you've deducted it all).
Clearly, tax shelters come in a wide range of possibilities with regards to both cost and effectiveness. Choosing a tax shelter can be a tricky decision, so if you're considering one of the more complex or unconventional shelters, speak with a tax professional first to be sure you're making the right choice for you.
