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Tax Shelters: An Important Part of Tax Planning

The term "tax shelter" is sometimes used pejoratively to refer to improper attempts to avoid tax. Such statements fail to make the crucial distinction between tax avoidance, on the one hand, and tax evasion on the other.

Tax avoidance is perfectly legal. After all, few people want to pay more tax to the government than they have to. The goal of smart tax planning is to minimize tax by making strategic decisions to shelter as much income as possible from tax.

To be sure, sometimes aggressive tax planning can go too far. You may even find yourself in need of legal counsel to respond to allegations by the IRS of tax evasion.

The basic point remains, however, that tax shelters are in the Internal Revenue Code for a reason. Congress has chosen to use the tax code to provide financial incentives for various activities, and that is a key purpose of tax shelters.

Amid uncertainty about what Congress may do next year in the tax arena, financial planners continue to work with clients to make good use of legal tax shelters.

This includes, for example, using IRAs, 401(k)s, and other types of retirement accounts effectively to maximize income and minimize tax.

It also includes making sound decisions on stocks. For example, a taxpayer who holds stocks that don't pay dividends can indefinitely postpone paying taxes on them.

By contrast, a taxpayer who makes frequent trades needs to be prepared for the possibility of having to pay short-term capital gains taxes.

Finally, given their importance to many modest investors, it is fitting to touch briefly on mutual funds. Here, too, it is important to minimize capital gains liability, such as by using index funds.

Source: "How to Cut Taxes on Your Nest Egg: Tax Shelters," The Street, Stan Lexenberg, 7-30-12

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