A tax shelter is a method or technique by which taxpayers can legally reduce their taxable income.

The term “tax shelter” has acquired some pejorative connotations, but the fact remains that there are many perfectly legal ways to shelter income from federal taxation.

These various tax shelters are created by the government to promote long term investments that help the economy and in turn, generate additional tax revenue. Most tax shelters practically involve a reduction or deferral of income tax.

Legal income tax shelters include investments, loan payments and retirement plans; all of which have a legitimate purpose in addition to providing income tax shelter. Illegal tax shelters generally don't have a true business purpose, but exist only to reduce taxes owed.

The IRS defines tax shelters as an investment that usually requires substantial contributions, often associated with a commensurate degree of risk. To the investor, a tax shelter usually means an investment that involves losses in the near-term, with the hopes of significant gains over the long-term.

The adjusted basis of the property you have contributed to the shelter;

The cash you have invested in the shelter;

Any loans you have taken out to invest in the shelter that you are personally liable for paying back.

So, what legal tax shelters are there for the ordinary taxpayer?

One of the most popular tax shelters is home ownership. As you may already know, when you buy a home your tax situation changes dramatically. Your mortgage interest and your property taxes are both deductible and, as your income grows, this becomes more and more important to your bottom line.

When you sell, your personal real estate could be an even bigger tax shelter. A single homeowner can exclude $250,000 in home-sale profit from taxation; the amount of tax-sheltered profit is double that for married couples.

Investing in real estate is a common tax shelter. In addition to the deductions it allows you to make (mortgage loan interest, mortgage insurance and property taxes), a real estate investment can help you grow wealth over time.

Retirement plans, such as pensions, 401(k) and 403(b) plans, and Individual Retirement Accounts (IRAs), have legitimate tax shelter qualities. You can make pretax contributions to these plans, which consist of a portion of your income before it's assessed for federal withholding. Every plan is different and has its own regulations and contribution caps. The caps are there to keep people from dumping all of their money into a plan to avoid taxation.

When you withdraw money or receive payments from one of these plans, the IRS assesses the tax on the amount withdrawn, but often at a lower rate than it would have taxed the original income.

If your employer provides benefits like health coverage, life insurance and education benefits, you can reduce your taxable income by taking advantage of these opportunities. Typically, you contribute part of your income to the benefit before your tax withholding is calculated.

A home-based business should be taken advantage of as it is one of the best tax shelters. If twenty-five percent of your home is used as an office, you can deduct twenty-five percent of the rent and basic utilities. If you use your car for business you can deduct a percentage of the payments and gas. Any expenses such as telephone service, internet service, remodeling, and office supplies can be deducted. A small-business owner can even deduct a family vacation, as long as he vacations in an area where he can hold a business meeting or do a small amount of work-related research or networking. There are many options available for legitimate tax shelters for small business owners.

Nevertheless, you should be aware that only contributions made to qualified organizations are taken into account.

Annuities, the interest on which are tax-deferred, are another popular tax sheltering technique. Taxpayers who purchase annuities aren’t limited by annual caps on their contributions, such as are imposed on IRAs, and they also aren’t required to report, or pay tax on any of the interest earned by the annuity until the money is actually drawn out. Since most annuities last at least seven years, and often many more, the compounding of the interest earned grows much more than if taxes were due annually on the earnings, as they are with most bank savings accounts and certificates of deposit.

A perfectly legitimate way to invest money and avoid paying income taxes on your gains is through municipal bonds and municipal bond funds, which are exempt from both federal and state income taxes.

Long-term investments are a great way to save.

Qualified dividends (as opposed to ordinary dividends) are taxed at a 15% percent rate. To be eligible as a qualified dividend, the dividends must be from a domestic corporation or a qualifying foreign corporation and you must hold the stock "for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date."

The special tax rates on long-term gains and qualified dividends will expire on December 31, 2012.

There are certain heavy industries, such as mining or oil drilling operations, that can spend a lot of capital money on exploration, and dedicate years of effort before generating real income for investors.

To encourage investment in these types of industries, the U.S. tax code allows the cost of exploration to be distributed to shareholders in the form of a tax deduction. This mechanism allows investors an immediate income tax savings, as well as the ability to realize future gains from the exploration effort.

The IRS allows individuals to claim these exploration losses only as an offset to passive investment income, not all earned income.

The downside is there are never any guarantees you will hit oil or gas. These deductions lose their shine when there is no income to offset them.

Tax patents are controversial. According to some, "tax patents amount to "government-issued barbed wire" to keep some taxpayers from getting equal treatment under the tax code." Examples of tax patents are: funding of a grantor retained annuity trust (GRAT) with non-qualified stock options, and tax-deferred real estate transactions.

Questionable tax shelters may include, beside offshore investments, financing arrangements whereby one person pays an extremely high rate of interest on money invested.  By doing so, the individual can reduce the income associated with the investment.  When the investment is withdrawn, a large capital gain is then realized.  The tax shelter occurs because capital gains are taxed at a lower rate than interest or dividend payments.

While tax shelter fraud is most commonly associated with corporations, individuals abusing annuities and trusts can also be charged with tax evasion.

Since we started with a quote, seems only appropriate to end with one as well:

“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”

To make good and legitimate use of this truth, make sure to enlist the help of a tax professional.