What Are the Most Common Tax Shelters?

The term “tax shelter” is often associated with complex and illicit schemes, but it more broadly refers to any legal method used to reduce a person’s tax liability. The government permits and encourages many of these strategies through the tax code to promote specific economic behaviors like saving for retirement.

Legal tax avoidance involves using IRS-sanctioned methods, such as deductions, credits, and tax-advantaged accounts, to minimize the amount of tax owed. In contrast, tax evasion involves willfully underreporting income or claiming fraudulent deductions. This article will focus on common and legal tax shelters available to a wide range of taxpayers.

Tax-Advantaged Savings Accounts

The federal government provides incentives for individuals to save for long-term goals like retirement and healthcare through specially designated savings accounts. These accounts offer tax benefits that are not available through standard savings or brokerage accounts. They are one of the most accessible methods for sheltering income and investment growth from taxation.

Employer-sponsored retirement plans, such as 401(k)s and 403(b)s, are a common starting point. Contributions to these plans are often made on a pre-tax basis, which lowers your current taxable income. For 2025, an employee can contribute up to $23,500, and many employers also offer a matching contribution.

The funds within the account grow tax-deferred, meaning you do not pay taxes on dividends or capital gains each year. The tax code also allows for catch-up contributions. Savers age 50 and over can contribute an additional $7,500, while a 2025 provision allows those aged 60 to 63 to contribute up to $11,250.

Individual Retirement Arrangements (IRAs) offer another avenue for tax-advantaged saving. For 2025, you can contribute up to $7,000, or $8,000 if you are age 50 or older. The two main types, Traditional and Roth IRAs, differ in their tax treatment.

Contributions to a Traditional IRA may be tax-deductible, lowering your current income, with taxes paid on withdrawals in retirement. Conversely, Roth IRA contributions are made with after-tax dollars, but qualified withdrawals in retirement are tax-free. Eligibility to contribute to a Roth or deduct for a Traditional IRA is subject to income limitations.

A Health Savings Account (HSA) is available for those in a high-deductible health plan (HDHP). For 2025, an HDHP must have a minimum deductible of $1,650 for self-only or $3,300 for family coverage. HSAs have a “triple tax advantage”: contributions are tax-deductible, funds grow tax-free, and withdrawals for qualified medical expenses are tax-free. In 2025, individuals can contribute up to $4,300 for self-only coverage and up to $8,550 for family coverage.

Tax-Efficient Investment Strategies

Managing tax liability is a component of investing, particularly within a standard taxable brokerage account. Several strategies can help manage the tax impact of investment gains and losses by focusing on the timing of sales and the type of assets held.

A core strategy involves holding appreciated assets for more than one year before selling. The tax code distinguishes between short-term capital gains from assets held one year or less and long-term capital gains. Short-term gains are taxed at ordinary income tax rates, while long-term gains are taxed at preferential rates of 0%, 15%, or 20%, depending on the investor’s taxable income.

Another technique is tax-loss harvesting, which involves selling investments that have decreased in value to realize a loss. These realized losses can be used to offset realized capital gains elsewhere in your portfolio. If your losses exceed your gains, you can use up to $3,000 of the excess loss to reduce your ordinary income for the year. Any remaining losses can be carried forward to future years. This strategy requires avoiding the “wash-sale rule,” which prohibits you from claiming the loss if you purchase a “substantially identical” security within 30 days before or after the sale.

Investing in municipal bonds can also be a tax-efficient strategy, particularly for those in higher tax brackets. Interest income from most municipal bonds is exempt from federal income tax. If you purchase bonds issued by your own state or municipality, the interest may also be exempt from state and local taxes. This means a municipal bond may offer a higher after-tax return than a corporate bond with a higher stated interest rate.

Maximizing Tax Deductions

Tax deductions reduce your Adjusted Gross Income (AGI), which is the figure used to calculate your final tax bill. By lowering your AGI, deductions decrease the amount of your income that is subject to tax. To benefit from these, a taxpayer must itemize their deductions, which is only advantageous if the total exceeds the standard deduction amount.

Deductions related to homeownership are among the most significant for many Americans. The mortgage interest deduction allows homeowners to deduct the interest paid on up to $750,000 of home acquisition debt. This limit is scheduled to expire after 2025, at which time it will revert to $1,000,000 if not extended by Congress.

Homeowners can also deduct property taxes paid to state and local governments. This is subject to the overall State and Local Tax (SALT) deduction cap, which is limited to $10,000 per household per year. This cap is also scheduled to expire at the end of 2025.

Charitable contributions made to qualified organizations provide another deduction. You can deduct the value of cash and non-cash donations, with the amount limited by a percentage of your AGI. For cash contributions to most public charities, the limit is 60% of AGI, but this is scheduled to revert to 50% after 2025.

For donations of appreciated property like stocks held for more than a year, the limit is 30% of AGI. Any contributions that exceed these limits can be carried forward and deducted for up to five subsequent years.

Business owners and self-employed individuals have access to a unique set of deductions. The Qualified Business Income (QBI) deduction allows owners of pass-through entities to deduct up to 20% of their qualified business income. This deduction is subject to limitations based on the taxpayer’s income and the nature of the business and is scheduled to expire after December 31, 2025.

Additionally, self-employed individuals can deduct one-half of the self-employment taxes they pay. This helps to offset the cost of paying both the employee and employer portions of Social Security and Medicare taxes.

Understanding Tax Credits

While both deductions and credits reduce your tax liability, they operate differently. A tax deduction lowers your taxable income, and its value depends on your marginal tax bracket. A tax credit provides a dollar-for-dollar reduction of the actual taxes you owe. For instance, in the 22% tax bracket, a $1,000 deduction saves you $220, whereas a $1,000 tax credit saves you the full $1,000.

The Child Tax Credit provides a benefit for parents with qualifying children under the age of 17. For the 2025 tax year, the credit is worth up to $2,000 per child. A portion of this credit, up to $1,700, is refundable, meaning you can receive it as a refund even if you don’t owe any federal income tax.

The American Opportunity Tax Credit (AOTC) is available for qualified expenses for the first four years of higher education. It provides a maximum annual credit of $2,500 per eligible student. Up to 40% of the AOTC, or $1,000, is refundable.

The government also uses tax credits to encourage specific consumer behaviors. The Clean Vehicle Credit offers a credit of up to $7,500 for the purchase of a new qualifying electric vehicle and up to $4,000 for a used one. The Energy Efficient Home Improvement Credit provides a credit of up to 30% of the cost of certain energy-saving home upgrades, with annual limits for specific improvements.