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
Types of Taxable IncomeWe’ve mentioned that a tax shield reduces your overall taxable income—but what exactly is taxable income?
General IncomeBasically, your taxable income is the portion of your income that’s subject to federal income tax. The IRS may tax your:
- Stock ownership
Fringe BenefitsYou’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.
BarteringYou’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 ShieldsHere are some great tax shields that are perfect for the everyday taxpayer.
Amortization“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
Depreciation“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.
Medical ExpensesAccording 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
Charitable ContributionsCharitable 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.
MortgagesYou 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
Child Care ExpensesIf 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 BusinessesIf you own a small business, you can boost your tax savings by taking advantage of the following tax shields.
AmortizationBusinesses can deduct amortization for:
- Business-related loans
- Development of a patent or new product
DepreciationA business is more likely to have depreciable assets than an individual taxpayer. These assets might include:
- Business-owned property
- Company vehicles
- Company equipment
Business ExpensesThere are plenty of business expenses that are tax deductible, like:
- Cost of goods sold
- Operating expenses
- Business travel
- Business meals
Startup CostsIf 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