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What is a tax shelter?

How does it work?

In simplest terms, a tax shelter is any strategy that allows you legally reduce your taxes or decrease your taxable income. Most shelters, including charitable contributions, provide a means of establishing losses in order to offset the money you’ve earned over the year. Others effectively lower your income prior to taxation; however, these types of shelters tend to require a greater investment up-front. To determine which shelters are most appropriate for you and your family (or business) you’ll first want to determine what kind of taxable income you possess.

What kind of income do I have?

Any trade or business venture where you don’t take an active, continuous, or substantial role—what the IRS defines as a “material participant”—is eligible for being listed as passive activity income. To qualify for this status, though, you’ll need to pass seven different tests for material participation (including the number of hours you spend on the activity in relation to any other individuals involved). Please be sure to review the requirements with a tax advisor before you submit for the tests. Real estate rental income, for instance, will usually register as passive for all seven. Active income, on the other hand, such as wages, tips, salaries, commissions, interests and dividends, and any trade or business where you’re deemed a material participant, will almost always register as positive under the tests.

Common methods for adjusting taxes and taxable income

Once you’ve determined which kinds of income you possess, you can develop a strategy for reducing your tax burden. Some of the more common methods include:

  • Lowering the tax rate of active incomes.—Holding onto an investment, such as a stock, bond, or real estate, for a specific period of time (typically a year or longer) can qualify you for long-term capital gains taxes, which is often significantly lower than a short-term one.
  • Increasing your itemized deductions—Contributing to charitable organizations and clearly documenting you’re your medical, household (mortgage interest, state and local taxes) and job-related expenses can also help to qualify you for a greater number of income deductions. Individual deductions “down-rate” or lower your income for the purposes of determining what’s taxable. Their effect, however, is dependent on your tax bracket: a $1,000 deduction, for example, will save you $280 in taxes if your bracket is 28% ($1,000 x .28 = $280).
  • Deferring income to another year—401(k), IRA, annuity, or similar “tax-deferred” plan allows you to reserve your income for later in life (usually retirement). With deferrals, you don’t pay taxes until you actually withdraw the money*, which allows you to effectively build assets for decades before paying at – in all likelihood – a lower rate
  • In simplest terms, a tax shelter is any strategy that allows you legally reduce your taxes or decrease your taxable income.

    *Withdrawals may be subject to regular income tax, and if made prior to age 59 ½, may be subject to a 10% IRS penalty.

    This material is for informational purposes only. Neither New York Life nor its agents provide tax, legal or accounting advice. Please consult your own tax, legal or accounting professional before making any decisions.

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