What is tax avoidance?
You can avoid paying higher taxes by reducing your taxable income
Paying taxes is one of the certainties in life.
But many Americans may be overpaying taxes each year, resulting in billions of dollars in unpaid tax refunds. In fact, in 2019 alone, the IRS claimed that there was $1.5 billion in tax refunds waiting to be sent out.
One way to ensure you’re getting the most from your tax refund is to employ tax avoidance strategies. Tax avoidance is a legal way to pay less in federal and state taxes. Here’s how it works, how to make sure you’re doing it legally and a few ways you can avoid taxes.
Key insights
- Tax avoidance is a legal way of lowering your income taxes.
- Tax avoidance strategies use the U.S. tax code to reduce taxable income or increase your refund through tax deductions and credits.
- Tax avoidance is legal, while tax evasion is illegally hiding your income from the IRS.
- There are dozens of ways to avoid taxes, including contributing to retirement accounts, owning real estate or running a small business.
How tax avoidance works
Tax avoidance refers to strategies that can help taxpayers legally owe less in personal or business income taxes. This process involves taking actions that allow taxpayers to claim as many credits and deductions as possible on tax returns.
“Common tax avoidance strategies include donating appreciated assets instead of cash, Section 179 expense for business equipment purchases, and Roth conversions to pay taxes in years when your income is lower,” said Jacob T. Rothman, a financial advisor at Rothman Investment Management.
Tax avoidance strategies follow tax laws that are put in place to help encourage certain actions, such as investing or getting an education. Tax laws are created in Congress and signed into law by the president.
The U.S. Internal Revenue Code (IRC) is extremely complex, as many layers of tax laws have been added or amended over the years. This makes it difficult for average Americans to take advantage of many tax avoidance strategies. Find a licensed tax professional to assist with personal and business taxes. They will get you the most out of the tax laws in place.
Tax avoidance vs. tax evasion
“Tax avoidance is simply using the tax rules to plan your actions for paying only the minimum tax due,” said Rothman. “Tax evasion is illegally hiding income to make your tax bill less than what your actual income would generate according to the law.”
Some examples of tax avoidance are:
- Claiming the child tax credit
- Contributing to a traditional IRA
- Deducting medical expenses
- Investing in tax-free municipal bonds
These are perfectly legal and allowed by the U.S. tax code.
Some examples of tax evasion are:
- Falsely claiming children that aren’t your dependents
- Underreporting income
- Hiding interest or dividends earned from investments
- Deducting personal expenses through your business
With these being illegal, they may be prosecuted as criminal charges. This could lead to substantial penalties and fees or even jail time.
Ways to legally avoid taxes
Paying taxes is part of being a U.S. citizen, but the tax code incentivizes certain actions. There are hundreds of ways to legally avoid paying extra taxes. Here are a few of them:
Standard or Itemized Deductions
The U.S. tax code allows you to deduct a certain amount each year, depending on your family size. This is known as the “standard deduction,” and since 2017, this amount has been significantly lowering taxpayers’ taxable income.
The current standard deduction is the amount you can claim to reduce your taxable income:
- $14,600 for single filers
- $29,200 for married filing jointly (or qualifying surviving spouse)
- $21,900 for head of household
You can also choose to itemize your deductions, meaning keep receipts for expenses incurred throughout the year and input those into your tax return. If the total expense amount exceeds your standard deduction, you can save even more on taxes.
Here are a few examples of expenses you can itemize:
- Mortgage insurance
- Real estate taxes
- Medical expenses (over 7.5% of adjusted gross income)
- Capital losses
- Sales or property taxes
- Charitable donations
Retirement contributions
Contributing to certain retirement accounts will allow you to deduct contributions and lower your taxable income. Workplace retirement accounts (401k, 403b, 457) or an individual retirement account (IRA) allow you to deduct contributions from your taxable income.
You can also contribute to small business retirement plans, such as a SIMPLE, a SEP IRA or a Solo 401(k) account. These lower your taxable revenue in the business and can save a lot of money in taxes.
If you invest in a “traditional” retirement account, you can deduct the contributions from your taxes in the year you make them. But if you invest in a “Roth” retirement account, you can’t deduct your contributions, but you can withdraw funds tax-free in retirement.
All of these retirement strategies are a form of tax avoidance.
» MORE: What is an IRA?
Tax credits
In addition to tax deductions, you can qualify for tax credits, which reduce the taxes you owe. Tax credits can have a better impact than deductions because, while deductions lower your taxable income, tax credits actually reduce what you owe (or increase your refund).
Some examples of tax credits include:
- Earned income credit
- Child tax credit
- Education credit
- Saver’s tax credit
- Energy efficient vehicle credit
Running a small business
If you own a small business, you have more deductions available to you than most taxpayers. This is mainly due to being able to use your home or vehicle for business purposes and write off the expenses.
If you work from home or use an office space out of your residence, the home office deduction allows you to deduct a portion of your mortgage, taxes, and utilities against your business income. You can also deduct a vehicle used for work, either mileage or the cost of the vehicle itself.
Small business owners pay higher taxes than many others, as they pay additional self-employment taxes that W-2 employees don’t. However, the amount available deductions can help them reduce their overall taxes.
» MORE: Tax deductions for homeowners in 2024
Owning real estate
Rental real estate offers quite a few tax deductions, including mortgage interest, taxes, repairs and improvements. In addition, rental real estate owners can depreciate the home based on the price paid (plus any improvements), giving real estate owners a massive tax deduction.
On the personal real estate side, homeowners can qualify for a capital gains exclusion on the sale of a personal residence - up to $250,000 for a single homeowner - or $500,000 for those married filing jointly. So, if you sell your home for a massive gain, you might not owe any taxes on that income.
Offshoring
Offshoring is the process of individuals or businesses moving assets to another “tax-friendly” country to avoid certain taxes. While there’s a fine line between offshoring tax avoidance and tax evasion, loopholes in the U.S. tax code allow offshoring to happen legally.
FAQ
Is tax avoidance ethical?
Tax avoidance is legal, but saying it’s “ethical” is up for interpretation. While the tax code itself is designed to incentivize specific actions, many believe it allows loopholes that lower taxes for ultra-wealthy individuals. Meanwhile, lower-income taxpayers are still paying a higher percentage of income tax. Because of that, tax avoidance can be seen as unethical. However, if you follow the tax code and lower your income taxes legally, this may be seen as an ethical approach.
What is a tax shelter?
Tax shelters are accounts and assets that offer tax deductions and credits, lowering taxes owed to the IRS. This can include retirement accounts, real estate, or businesses that can legally lower your tax burden.
What is the standard deduction?
The standard deduction is an income tax deduction given to Americans based on their filing status. This deduction allows Americans to lower their taxable income by the deduction amount. As of 2024, the standard deduction is $14,600 for single filers, $29,200 for married filing jointly (or qualifying surviving spouse), and $21,900 for head of household.
Bottom line
Tax avoidance is a legal approach to lowering your income tax burden. You can take advantage of tax deductions and credits to reduce what you owe or even boost your tax refund. But, the U.S. code is complicated. So, it’s a good idea to work with a licensed tax professional to prepare your tax return to ensure you can (legally) take advantage of the tax avoidance strategies available to you.
Article sources
- IRS, “Time is running out: Taxpayers missing $1.5 billion in refunds for 2019 must file by July 17.” Accessed Feb. 2, 2024.
- House.gov, “26 USC 7201: Attempt to evade or defeat tax.” Accessed Feb. 2, 2024.
- IRS, “IRS provides tax inflation adjustments for tax year 2024.” Accessed Feb. 2, 2024.
- IRS, “Credits and deductions for individuals.” Accessed Feb. 02, 2024.
- Congress.gov, “Tax Havens: International Tax Avoidance and Evasion.” Accessed Feb. 2, 2024.
