Taking advantage of tax shelters through strategic planning is a key aspect of any good financial plan. In this article, we define tax shelters as well as discuss their advantages, disadvantages, and provide many examples.
Tax Shelters – Definition
A tax shelter is any account which provides tax advantages to the owner in the form of tax efficiency, deferment, or exemption.¹
Advantages
Tax efficiency involves the reduction in taxes owed when transactions occur. In a non-tax advantaged account, capital gains taxes are owed on appreciated stocks when they are sold. This means that if you want to sell one stock and then buy another you would owe taxes immediately on the money. However, if the transaction occurs within a tax advantaged account, you gain tax efficiency by not having to pay immediate taxes on the gain.
Tax deferment allows the owner to reduce taxes owed now and instead defer those taxes to be paid at some point in the future. Such an arrangement can provide many benefits, such as allowing more money to be saved than otherwise would be possible. Traditional 401(k) and IRAs are the best example. Money placed in a traditional IRA is tax deductible in the year of contribution, which means no taxes are owed on the immediate income. In addition, taxes on the income plus earnings are deferred until the money is withdrawn.
Tax exemption allows the complete or partial reduction of taxes owed on income. Roth accounts allow the exemption of all future income earned within the account. This applies to both Roth 401(k) and IRAs. Health Savings Accounts (HSA) exempt from taxes any income spent on health expenses. Educational Savings Accounts (ESA) exempt from taxes any income spent on qualified education expenses.
Disadvantages
Many tax advantaged accounts place restrictions on withdrawals or how the money in the account can be utilized. For example, education savings accounts are restricted to withdrawals for education related expenses. Meanwhile, retirement savings accounts usually cannot be accessed until you are at least 59.5 years old.
If you want to withdraw money from a tax advantaged account without meeting the government designated requirements, the IRS will impose a tax penalty as a percentage of the withdrawal amount. The tax penalty is in addition to the loss of tax advantaged benefits on the money withdrawn. For instance, you’ll have to immediately pay the taxes on 401k withdrawals and an additional 10% penalty, if you withdraw money outside of certain conditions.
Some tax benefits are available in the United States that only exist outside of tax advantaged accounts. One particular benefit is a stepped-up tax basis upon death. If you purchase stock in a normal taxable account, then your heirs will not have to pay tax on the increased value of the shares when you die. However, this exclusion of capital gains taxes takes effect only outside of tax advantaged accounts.
Examples of Tax Advantaged Accounts
- 401(a)
- 401(k)
- 403(b)
- Traditional Individual Retirement Account (IRA)
- Roth IRA
- 457 plan
- 529 plan
- Coverdell Education Savings Account (ESA)
- Health Savings Account (HSA)
- Thrift Savings Plan (TSP)
- Individual Development Account (IDA)
1. There are other forms of tax shelters available to corporations and other legal entities but they will be ignored as this site primarily focuses on individual investors.
