What Are Good Tax Shelters for Reducing Taxable Income?

The term “tax shelter” refers to any legal method used to reduce taxable income. These are not secrets but financial arrangements sanctioned by the government to encourage specific behaviors, such as saving for the future or investing in certain economic sectors. The Internal Revenue Service (IRS) provides the framework for this financial planning, a practice known as tax avoidance. It is important to distinguish legal tax avoidance, which uses the tax code to lower your bill, from illegal tax evasion, which involves concealing income or falsifying records.

Retirement Savings Vehicles

The most accessible tax shelters are retirement savings accounts, designed to encourage long-term savings with tax advantages. The primary categories are employer-sponsored plans, like 401(k)s and 403(b)s, and Individual Retirement Arrangements (IRAs). These vehicles provide a way to lower your current tax bill or secure tax-free income in retirement.

With a traditional, pre-tax plan, contributions are taken from your paycheck before federal and state income taxes are calculated. This reduces your adjusted gross income (AGI) for the year, resulting in a lower tax bill. For 2025, employees can contribute up to $23,500, with an additional $7,500 catch-up contribution for those age 50 and over. The money grows tax-deferred, so you do not pay taxes on investment gains until withdrawal.

The alternative is a Roth account, available in both employer plans and as IRAs. You contribute money that has already been taxed, so there is no immediate deduction. The benefit comes later, as your contributions and all subsequent investment earnings grow completely tax-free. Qualified withdrawals in retirement, after age 59½, are not subject to federal income tax.

IRAs offer similar benefits for those without an employer plan or who wish to save more. A Traditional IRA allows for tax-deductible contributions, while a Roth IRA uses after-tax dollars for tax-free growth and withdrawals. For 2025, the annual IRA contribution limit is $7,000, with a $1,000 catch-up for individuals aged 50 and over.

Investment-Based Tax Strategies

Beyond retirement accounts, certain investment strategies offer their own tax shelters. These methods focus on how investment returns are generated and taxed. Two prominent strategies are investing in municipal bonds and utilizing tax-loss harvesting.

Municipal bonds are debt securities issued by states and cities to fund public projects. The primary advantage is that the interest income they generate is exempt from federal income tax. If you purchase bonds issued by your own state, the interest may also be exempt from state and local taxes, which is attractive to individuals in higher tax brackets.

Tax-loss harvesting involves selling investments that have decreased in value to realize a loss for tax purposes. These realized capital losses can offset capital gains from profitable sales, reducing or eliminating the taxes owed on those gains. If your losses exceed your gains, you can use up to $3,000 of the excess to offset ordinary income, and any remaining loss can be carried forward to future years. Be aware of the “wash sale” rule, which disallows the loss if you buy a substantially identical security within 30 days of the sale.

Real Estate Investment Advantages

Investing in real estate provides tax advantages for owners of rental or business properties. These benefits revolve around depreciation, deducting operating expenses, and deferring capital gains taxes.

A primary benefit is depreciation, where the IRS allows you to deduct a portion of the building’s cost over time. For residential rental properties, this period is 27.5 years. This deduction is a non-cash expense that creates a “paper loss” to offset rental income.

Investors can also deduct operating expenses, which significantly reduces taxable rental income. Common deductible expenses include:

• Mortgage interest
• Property taxes
• Insurance
• Maintenance and repairs
• Property management fees
• Utilities

The Section 1031 exchange allows an investor to sell a property and defer capital gains taxes by reinvesting the proceeds into a “like-kind” property. This strategy enables capital to grow without an immediate tax consequence, but it requires following strict rules and timelines.

Business Ownership and Deductions

Owning a business unlocks a distinct set of tax-sheltering opportunities by allowing for the deduction of legitimate business expenses. For owners of certain businesses, specific deductions can also directly reduce their taxable income.

A benefit for owners of pass-through businesses, such as sole proprietorships and S corporations, is the Qualified Business Income (QBI) deduction. This allows eligible taxpayers to deduct up to 20% of their qualified business income. The calculation is subject to limitations based on income, business type, and W-2 wages paid, and this deduction is set to expire after December 31, 2025.

Another tool is Section 179, which allows a business to expense the cost of qualifying equipment in the year it is purchased rather than depreciating it over several years. For 2025, the maximum deduction is $1,250,000 on up to $3,130,000 of equipment purchased. This provides an immediate tax deduction for businesses investing in new assets.

Other Tax-Advantaged Accounts and Strategies

Beyond the previous strategies, several other accounts and methods offer tax-sheltering benefits. These tools are designed to encourage savings for specific goals like healthcare and education, or to promote charitable giving.

Health Savings Accounts (HSAs) have a unique “triple tax advantage.” To contribute, you must be enrolled in a high-deductible health plan (HDHP). Contributions are tax-deductible, the funds grow tax-free, and withdrawals are also tax-free when used for qualified medical expenses.

For education savings, 529 plans offer a tax-advantaged way to invest. While contributions are not federally deductible, many states offer a tax deduction or credit. The money grows tax-deferred, and withdrawals are tax-free when used for qualified education expenses.

Charitable contributions provide another avenue for tax reduction. When you donate to a qualified charitable organization, you may be able to claim a deduction on your tax return if you itemize. The amount you can deduct is subject to limits based on a percentage of your adjusted gross income.