What Is Tax Avoidance and How Is It Different From Tax Evasion?

What Is Tax Avoidance?

The term tax avoidance refers to 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.

Understanding Tax Avoidance

Tax avoidance is a legal strategy that many taxpayers can use to avoid paying taxes or at least lower their tax bills. In fact, millions of individuals and businesses use some form of tax avoidance to cut down how much they owe to the Internal Revenue Service (IRS) legally and legitimately. When used in this context, tax avoidance is also referred to as a tax shelter.

Taxpayers can take advantage of tax avoidance through various credits, deductions, exclusions, and loopholes, such as:

• Claiming the child tax credit
• Investing in a retirement account and maxing out your annual contributions
• Taking the mortgage tax deduction
• Putting money into a health savings account (HSA)

Credits and deductions (and, therefore, tax avoidance) must first be approved by U.S. Congress and signed into law by the president before they become part of the U.S. Tax Code. Once done, these provisions can be used for the benefit or relief of some or all taxpayers.

Tax avoidance is built into the Internal Revenue Code (IRC). Lawmakers use the Tax Code to manipulate citizen behavior by offering tax credits, deductions, or exemptions. By doing so, they indirectly subsidize certain 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.

Special Considerations

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. In fact, its sheer complexity causes many taxpayers to miss out on certain tax breaks. Taxpayers end up spending billions of hours each year filing tax returns, with much of that time used looking for ways to avoid paying higher taxes.

Families often have a difficult time making decisions about retirement, savings, and education because the tax code changes every year. Businesses especially suffer the consequences of a tax code that constantly evolves, which can affect hiring decisions and growth strategies.

Eliminating or reducing tax avoidance is at the core of most proposals seeking to change the Tax Code. Newer proposals often seek to simplify the process by flattening tax rates and removing most tax avoidance provisions. Proponents of establishing a flat tax rate argue that it would eliminate the need to pursue tax avoidance strategies. Opponents, however, call the flat tax concept regressive.

There are some tax policies, though, that disproportionately advantage citizens with higher incomes. For instance:

• Federal estate taxes are not levied on estates valued at less than $12.92 million in 2023, increasing to $13.61 million in 2024
• Long-term 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

Types of Tax Avoidance

As noted above, there are several ways that taxpaying entities can avoid paying taxes. This includes certain credits and deductions, exclusions, and loopholes that make up the U.S. Tax Code. The following are just a few of the tools taxpayers have at their disposal to take advantage of tax avoidance.

The Standard Deduction

The IRS reported that 87.3% of taxpayers used the standard deduction rather than itemizing their deductions in 2020. The standard deduction is $13,850 for single filers in 2023, increasing to $14,600 in 2024, and $27,700 for married couples filing jointly in 2023, increasing to $29,200 in 2024.

For most Americans, that negates the usefulness even of the mortgage interest deduction—especially now that the Tax Cuts and Jobs Act (TCJA), which was signed in 2017, increased the standard deduction and capped deductions for state and local taxes at $10,000.

But 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.

Retirement Savings

Saving money for your retirement means you're probably engaging in tax avoidance. And that's a good thing. 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 is owed when it is withdrawn after the saver retires. The retiree's taxable income will probably be lower as well as the taxes owed. That's tax avoidance.

Roth plans allow investors to save 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.

Workplace Expenses

Before 2018, you could use deductions through your workplace to avoid federal taxes. In some states, you still may be able to claim certain expenses that are not reimbursed through your employer on your annual tax return. These workplace expenses should be considered necessary to do your job. Some examples include mileage on a personal vehicle, union dues, or tools you may need.

Offshoring

There are loopholes in the U.S. Tax Code that allow corporations and high-net-worth individuals (HNWIs) to move their money to offshore tax havens. These are locations that have looser regulations, more favorable tax laws, lower financial risks, and confidentiality. Going offshore by setting up subsidiaries or bank accounts allows these taxpaying entities to avoid paying (higher) taxes in their home countries.

Tax Avoidance vs. Tax Evasion

People often confuse tax avoidance with tax evasion. While both are ways to avoid having to pay taxes, they are very different. Tax avoidance is very legal while tax evasion is completely illegal.

Tax evasion happens when people underreport or fail to report income or revenue earned to a taxing authority like the IRS. You are guilty of tax evasion if you don't report all of your income, such as tips or bonuses paid by your employer. Claiming credits to which you aren't entitled is also considered tax evasion. Some taxpayers are guilty of tax evasion by not filing their taxes or not paying their taxes even if they've filed returns.

Tax evasion is a serious offense. Entities that are found liable can be fined, jailed, or both.

The Bottom Line

Contrary to what most people think, tax avoidance is a very legal way to avoid paying too much in taxes. There are different strategies in place that you can use to completely avoid paying or lower your tax liability. For instance, you can use the standard deduction to avoid paying excess taxes on your annual income. And if you save for retirement in an IRA, the amount is also considered a tax avoidance strategy. But don't confuse it with tax evasion. which is illegal. When in doubt, consult a tax or financial professional about how to ensure that you're following the law.