During tax time, you might hear the term, “tax shield” thrown around by tax professionals. But what is a tax shield, exactly? We’ll discuss what a tax shield is, and how you can use it to boost your tax savings.
What is a Tax Shield?
A tax shield is a reduction in taxable income for an individual or corporation. It reduces the amount of your taxable income for the current tax year, or defers it to the next year.
How do you wield a tax shield? All you’ve got to do is claim a tax deduction when you’re filing your tax return. Common tax deductions include:
- Charitable Contributions
- Medical Expenses
- Mortgage Interest
- Child Care Expenses
- Earned Income Tax Credit
Any tax deduction can be considered a tax shield—you’ve just got to find one that you’re eligible for.
Types of Taxable Income
We’ve mentioned that a tax shield reduces your overall taxable income—but what exactly is taxable income?
Basically, your taxable income is the portion of your income that’s subject to federal income tax. The IRS may tax your:
- Stock ownership
You’ll also be taxed on fringe benefits. A fringe benefit is compensation you receive for good performance of your services. A tip is the most common type of fringe benefit—you’ll likely get tipped for being a good waitress or informative tour guide. But fringe benefits aren’t limited to money. If you’re given any kind of physical belonging for compensation, the value of that item can be taxed by the IRS. So if you’re rewarded with a bonus or a new car, the bonus or the value of the new car can be taxed.
The fringe benefit may still be taxed even if it’s given to a family member. If your spouse, for instance, is given a timeshare as compensation for your work performance, you’re still responsible for reporting the value of the timeshare on your tax return.
You’ll also be taxed on compensation you received through bartering. Let’s say you exchange one product or service for another—maybe you find someone with whom you trade your sofa for a new armchair. The new armchair counts as “compensation.” You could be taxed on the fair market value of the armchair.
The same goes for bartered services. Let’s say that you use your skills to paint your neighbor’s house, and in return your neighbor uses their skills to fix the roof on your home. The carpet counts as “compensation” and so you could be taxed on the fair market value of the roof-fixing service.
Types of Tax Shields
Here are some great tax shields that are perfect for the everyday taxpayer.
“Amortization” is an unusual word, but there’s a good chance that you’re doing it in your everyday finances. Amortization is when you split a loan into regular payments over a predetermined length of time (known as an amortization schedule).
Common amortization payments include:
- Mortgage Loans
- Auto Loans
- Student Loans
Auto loan interest is not tax deductible, unfortunately. Mortgage loan interest may be tax deductible, but that’s a pretty dense topic that we’ll cover later. Student loan interest, on the other hand, is absolutely tax deductible.
Typically you can deduct all the interest you paid on the loan during the whole tax year. The interest is capped at $2,500 per return, not per person—in other words, if you and your spouse are filing jointly and you collectively paid $3,000 in student loan interest, you’ll still only be able to deduct up to $2,500.
“Depreciation” is when one of your assets loses value. The most common depreciative assets include your house and your vehicle—these are things that naturally get worn down over time, and so they become less valuable. While properties tend to gain value over time (appreciate), the physical structure of your home is more likely to depreciate.
You can claim a tax deduction that accounts for depreciation of your assets. Unfortunately, you can only claim a depreciation deduction if your asset is being used for business purposes.
But do you have a rental property? A rental property is an asset that’s used to generate income, so you can claim a depreciation deduction on it so long as it’s not your primary residence.
Depreciation is no doubt the most difficult tax shield to calculate, so it’s highly recommended that you use a tax preparation service, like Community Tax, if you plan on claiming a tax deduction in this area.
According to the IRS, you can deduct unreimbursed medical expenses that are more than 7.5% of your gross income—in other words, you might be able to deduct any medical expenses that aren’t covered by insurance.
There are a few medical expenses you can’t deduct:
- Non-prescription drugs (except for insulin)
- Diet food
Basically, you can’t deduct anything related to your general health. The expenses you can deduct are related to doctor’s appointments, surgery, and exploratory procedures.
This is a very important tax shield to consider when you’re planning for tax savings. Let’s say you’re planning on having a year-end surgery. If your medical expenses are nearing 10% of your income, you might want to have surgery before the new year to push you over the threshold. If your medical expenses are already over 10%, you might want to postpone the surgery until after the new year so you can get closer to the threshold for the following year. Again, this might be a good area in which to speak with a tax professional.
Charitable contributions are great tax shields for the civic-minded taxpayer. Your charitable donations must be to a qualified, tax-exempt organization, and you’ve got to donate either cash or property. Depending on the status of the organization, you can deduct up to 30% or 60% of your adjusted gross income—a big reward being a charitable person!
Just be sure that you keep accurate records—keep any acknowledgement letters or appraisals that the organization gives you, and keep financial records, too.
Here’s another great perk: if your donations exceed the donation limit, you can carry them over to the next year.
Pro Tip: If you’re donating an asset, you can deduct up to 20% of capital gains on the asset you transfer.
You can deduct mortgage interest on your home! How much you can deduct depends on when you purchased your home:
- Before December 17, 2017: deduct up to $750,000
- After December 17, 2017: deduct up to $1 million
Only a standard mortgage is tax deductible. Mortgage points are deductible, too, but you can only deduct them in full so long as you purchased them to build, buy, or improve your primary residence. You can’t deduct the full amount for rental properties.
Child Care Expenses
If you have a child or dependent, there are several different tax shields you can take advantage of, including the:
- Child Tax Credit: Deduct up to $2,000 for each dependent under age 17 (other credits available for older children)
- Child and Dependent Care Credit: If you paid for childcare services (daycare, summer camp, babysitters) for dependents under age 13, you can deduct up to $3,000 for one dependent and up to $6,000 for two or more
Earned Income Tax Credit (EITC)
The Earned Income Tax Credit (EITC) is available for taxpayers who are earning a low to moderate income. It’s a very useful tax shield that could give you a large tax refund.
Good Tax Shields for Businesses
If you own a small business, you can boost your tax savings by taking advantage of the following tax shields.
Businesses can deduct amortization for:
- Business-related loans
- Development of a patent or new product
Loan interest is deductible via amortization. But so is business development. If your company is spending money to develop a new asset, you might consider spreading out this expense over several years rather than paying for the whole expense at once—this way, you can pay less tax on it in a given year. Make sure you’ve got a good bookkeeping service to help you plan out these payments.
A business is more likely to have depreciable assets than an individual taxpayer. These assets might include:
- Business-owned property
- Company vehicles
- Company equipment
Contact a tax professional to learn more about deducting for depreciation.
There are plenty of business expenses that are tax deductible, like:
- Cost of goods sold
- Operating expenses
- Business travel
- Business meals
If you run a business out of your home office, you may be able to deduct rent and utilities in your home. You can also deduct up to $5,000 in organizational costs.
If you’re a startup business, there are additional business expenses that you can deduct. You can get tax shields by claiming deductions on:
- New business assets (like new equipment and property)
- Small business loan fees
- Small business insurance
If your startup costs are $50,000 or less, you can deduct up to $5,000 of these startup costs (but it’s phased out over $50,000, and eliminated after $55,000).
You can only claim these deductions for the tax year in which the business opened, so keep that in mind when you’re considering launch dates.
How to Take Advantage of Tax Shields
Now that you know what a tax shield is, you need to know whether or not you should try and claim them.
When you file your tax return, you can either claim the standard deduction or you can choose to itemize your deductions. The standard deduction gives you a predetermined deduction that’s based on your tax bracket, while the itemized deductions can give you as much tax relief as you’re able to claim.
Many of the tax shields we discussed—but not all of them—can only be claimed when you itemize your deductions. However, many taxpayers no longer choose to itemize because the 2017 Tax Cuts and Jobs Act nearly doubled the standard deduction—now, lots of middle-class taxpayers get more tax relief from the standard deduction than they would be itemizing.
But if there are a lot of tax shields you’re able to claim, you shouldn’t assume that you’ll earn more tax savings from the standard deduction. Definitely consult with a tax preparation service. A tax service can pore through your finances and help you figure out whether you’re better off claiming the standard deduction or itemizing.