What is 'Tax Avoidance'
Tax avoidance is the use of legal methods to modify an individual's financial situation to lower the amount of income tax owed. This is generally accomplished by claiming the permissible deductions and credits. This practice differs from tax evasion, which uses illegal methods, such as underreporting income to avoid paying taxes.
BREAKING DOWN 'Tax Avoidance'
Most taxpayers use some form of tax avoidance. Even though it may seem negative, it really isn't. In fact, tax avoidance is a legal way for people or other entities to minimize their tax liability. These can be in the form of deductions or credits used to their advantage to lower their tax bills.
For example, individuals who contribute to employer-sponsored retirement plans with pre-tax funds are engaging in tax avoidance because the amount of taxes paid on the funds when they are withdrawn in retirement is usually less than the amount the individual would owe. Furthermore, retirement plans allow taxpayers to defer paying taxes until a much later date, which allows their savings to grow at a faster rate.
Tax Avoidance Is Encouraged
Tax avoidance is built into the Internal Revenue Code (IRC), which spans more than 75,000 pages. Lawmakers have used the IRC to manipulate taxpayer behavior by offering tax credits, deductions and exemptions in various aspects of people’s lives including healthcare, saving and investing, education, energy use and other activities. The tax benefits available in qualified retirement plans are to promote self-sufficiency in retirement. The death benefit of a life insurance policy is exempted from taxes to encourage family protection. Capital gains are taxed at a lower rate to encourage more investments. Interest deductions on home mortgages foster more home ownership.
Tax Avoidance Complicates the Tax Code
The expanding use of tax avoidance in the tax code has led to it becoming 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 is always changing, 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 their 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 reform the tax code. The proposals that have been introduced over the last decade seek to simplify the tax code by flattening the tax rates and removing most tax avoidance provisions. Tax reform proposals assume a lower, flat tax rate would eliminate the need to pursue tax avoidance strategies.
Tax Avoidance vs. Tax Evasion
Contrary to what you may believe, tax avoidance is encouraged and legal, despite any negative image it may conjure up. Tax evasion, on the other hand, is illegal. It happens when people underreport, or don't report at all, any income or revenue earned to a taxing authority. You can also evade taxes by not paying your taxes at all. Tax evasion is, in most places, a crime. If found guilty of committing tax evasion, the Internal Revenue Service (IRS) says people can serve jail time, pay a fine or both.