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 is allowable. It may also be achieved by prioritizing investments that have tax advantages, such as buying municipal bonds.
Tax avoidance is not the same as tax evasion, which relies on illegal methods such as underreporting income and falsifying deductions.
Tax Avoidance Vs. Tax Evasion
Tax Avoidance Explained
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.
- 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.
- At 2,600 pages, the U.S. Tax Code contains many other tax breaks, but it usually takes a professional tax preparer to figure them out.
Unfortunately, their combined efforts over decades have resulted in a U.S. Tax Code that is about 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. Most of those pages are apparently background material that even accountants don't bother to read.)
The sheer complexity causes many taxpayers to miss out on tax breaks they could benefit from claiming.
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 been increased to $12,000 for individuals and $24,000 for couples. For most Americans since 2018, that negates the usefulness even of the mortgage interest deduction.
Still, there are plenty of small business owners, freelancers, investors, and others who find it necessary to 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 of the annual savings, up to a limit that is revised yearly. The income taxes will be owed when the money 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 but 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. The saver has permanently avoided income taxes on the profits.
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 for everyone who inherits 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 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.
Since 2006, nearly 4,500 federal tax rule changes have been made to the Tax Code, most having to do with tax avoidance provisions.
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 tax reform argue that a lower flat tax rate would eliminate the need to pursue tax avoidance strategies.
Tax Avoidance vs. Tax Evasion
In short, most Americans practice tax avoidance. It is, in fact, a major American industry.
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 punishable by jail time, a fine, or both.