What Is Tax Avoidance?

Tax avoidance is the use of legal methods to minimize the amount of income tax owed by an individual or a business. This is generally accomplished by claiming as many deductions and credits as are allowable. It may also be achieved by prioritizing investments that have tax advantages, such as buying tax-free municipal bonds. Tax avoidance is not the same as tax evasion, which relies on illegal methods such as underreporting income and falsifying deductions.

Key Takeaways

  • Anyone who invests in a retirement fund, uses the mortgage deduction, or takes the child tax credit is practicing tax avoidance.
  • These are legal tax breaks offered to encourage certain behaviors, such as saving for retirement or buying a home.
  • Tax avoidance is unlike tax evasion, which relies on illegal methods such as underreporting income.
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Tax Avoidance Vs. Tax Evasion

Understanding Tax Avoidance

Millions of taxpayers use some form of tax avoidance if only by taking the child tax credit, investing in a retirement account, or taking the mortgage tax deduction. Every tax deduction and credit available in the U.S. Tax Code was placed there by the U.S. Congress for the benefit or the relief of some or all taxpayers.

The cap on the child tax credit, previously $2,000, has been raised to $3,000 for children ages six through 17 and $3,600 for children under six. This change is part of the American Relief Act and is effective for the 2021 tax year.

The combined efforts of Congress over decades have resulted in a U.S. Tax Code that is more than 2,600 pages long and far too complicated for anyone without an accounting degree to tackle. (The legend that the Tax Code contains 70,000 pages has been debunked. This figure represents annotated versions of the statutes that include related case law.

The Code's sheer complexity causes many taxpayers to miss out on tax breaks that they are eligible to claim.

Avoiding Tax Avoidance

In fact, more than 90% of individuals now use the standard deduction rather than itemizing deductions. In part, that is because the standard deduction has increased to $12,400 for individuals and $24,800 for couples for the 2020 tax year. The numbers edge up to $12,550 for individuals and $25,100 for couples in 2021.

For most Americans, that negates the usefulness even of the mortgage interest deduction—especially now that the same 2018 tax bill that increased the standard deduction capped deductions for state and local taxes at $10,000.

Still, there are plenty of small business owners, freelancers, investors, and others who save every business expense receipt that may be eligible for a deduction. Others leap to the IRS challenge and angle for every tax deduction and credit they can get.

Most Common Tax Avoidance Tactics

If you're saving money for your retirement, you're probably engaging in tax avoidance. And that's a good thing.

Many business owners, freelancers, and investors find it necessary to save every receipt that may be useful for the purpose of legal tax avoidance.

Every individual who contributes to an employer-sponsored retirement plan or invests in an individual retirement account (IRA) is engaging in tax avoidance.

  • If the account is a so-called "traditional" plan, the investor gets an immediate tax break equalling the amount they contribute each year, up to a limit that is revised annually. Income taxes on the money will be owed when it is withdrawn after the saver retires. The retiree's taxable income will probably be lower then, as will the taxes owed on that income. That's tax avoidance.
  • If it is a Roth plan, the investor saves after-tax money and the tax break will come after retirement, in the form of tax-free savings. In this case, the entire balance of the account is tax-free. Roths allow the saver to permanently avoid income taxes on the money their contributions earn over the year.

How Congress Encourages Tax Avoidance

Tax avoidance is built into the Internal Revenue Code. Lawmakers use the Tax Code to manipulate citizen behavior by offering tax credits, deductions, or exemptions. By doing so, they are indirectly subsidizing various essential services such as health insurance, retirement saving, and higher education. Or, they may use the Tax Code to advance national goals, such as greater energy efficiency.

Some of these tax policies disproportionately advantage citizens with higher incomes. Federal estate taxes have been abolished on an estate valued at less than $11.58 million. Capital gains are taxed at a lower rate than most earned income. Mortgage interest is deductible on both a first home and a second (but not a third) home.

Tax Avoidance Complicates the Tax Code

The expanding use of tax avoidance in the U.S. Tax Code has made it one of the most complex tax codes in the world. Taxpayers spend billions of hours each year filing tax returns, with much of that time used looking for ways to avoid paying higher taxes.

Because the tax code changes every year to some extent, families have a difficult time making decisions about retirement, savings, and education. Businesses especially suffer the consequences of an ever-evolving Tax Code that affects hiring decisions and growth strategies.

Eliminating or reducing tax avoidance is at the core of most proposals seeking to change the Tax Code. The proposals that have been introduced over the last decade seek to simplify the process by flattening tax rates and removing most tax avoidance provisions. Proponents of establishing a flat tax rate, for example, argue that it would eliminate the need to pursue tax avoidance strategies. (Opponents, however, call the flat tax concept regressive.)

Tax Avoidance vs. Tax Evasion

In short, most Americans practice some form of tax avoidance in order to minimize taxes due. Indeed, giving tax advice on how to do that is a major industry in America.

Tax evasion, on the other hand, is illegal. It happens when people underreport or fail to report income or revenue earned to a taxing authority. Some practice tax evasion by not paying taxes at all. Tax evasion is serious and is punishable by jail time, a fine, or both.