A tax shelter is a broad term applied to any activity or strategy that reduces the overall tax liability of a person or entity. Some tax shelters are perfectly legal and even encouraged by the government, such as business deductions for operating losses, which can help new businesses grow. Others are abusive and illegal, such as offshore companies that absorb profits tax-free. A Roth IRA is a tax-favored retirement savings account and a legal tax shelter.
A tax shelter can be any of hundreds of strategies and activities that reduce the amount of money that a person or business owes in taxes. The government offers a wide variety of deductions and credits that individuals and businesses can claim to reduce their taxes, such as educational credits, deductions for interest on loans, advantages for buying houses, new equipment and energy efficient cars. People have also devised illegal or somewhat legal strategies for saving money on taxes, such as setting up businesses or accounts in other countries that have lower tax rates.
Roth IRAs are one of two types of individual retirement accounts that individuals can use to save for retirement. Banks and brokerage firms administer Roth IRAs for individuals. An individual earns money, pays taxes on that money and can then deposit that money into a Roth IRA and use it to purchase investments. The invested money grows tax-free until he takes it out after reaching retirement age.
IRAs and Tax Shelters
A Roth IRA is one kind of tax shelter. In the complex and wide world of tax shelters, the Roth is a simple and very accessible one. Roth IRAs are legal tax shelters that the government created -- and wants people to take advantage of -- in order to encourage individuals to save for retirement. However, the government limits how much money a person can put into this account every year, which is $5,000 as of the time of publication.
The Roth IRA is only one of hundreds if not thousands of tax shelters. Many shelters are either very complicated to set up, illegal or both. For example, a person or group can set up a small business that incurs losses in its first years and claim tax deductions for those losses once the business starts generating profits, reducing the tax bill -- which is perfectly legal. The business or its owners can also set up accounts or a shell business in a country that has no income tax and transfer profits to those accounts to avoid U.S. taxes -- which is illegal.
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