What Is Tax Avoidance?

By Maurie Backman Markets Fool.com

Every year, countless taxpayers look for ways to lower their taxable income and shield more of their hard-earned money from the IRS. This practice is known as tax avoidance, and while it may seem unscrupulous, it's actually perfectly legal.

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Tax avoidance is the use of legitimate methods to reduce the amount of income tax you owe the IRS. Common examples of tax avoidance include contributing to a retirement account with pre-tax dollars and claiming deductions and credits. Tax evasion, by contrast, is the illegal act of concealing or misrepresenting income to avoid taxation, and it's not only dishonest, but also punishable by law.

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The tax code supports tax avoidance

Though the words "tax avoidance" might sport somewhat of a negative connotation, in reality, the tax code is designed to help workers pay as little tax as possible. In fact, there are a number of IRS-sanctioned methods for avoiding taxes, the most common of which include:

  • Using pre-tax dollars to fund an IRA or 401(k).
  • Taking deductions for things such as mortgage interest, property taxes, medical expenses, and charitable contributions.
  • Claiming tax credits offered by the IRS.
  • Deducting business expenses to reduce your taxable income.
  • Holding investments longer to benefit from a lower capital gains tax rate.

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In fact, part of the reason the tax code is so complicated is that it's loaded with tax avoidance provisions. And the more tax avoidance measures you take, the more money you stand to save.

Is tax avoidance illegal?

Tax avoidance is perfectly legal provided you follow the rules. For example, you're allowed to deduct charitable contributions on your taxes, so if you give $500 to charity over the course of a given tax year, you have every right to deduct that amount on your return. But if you lie and claim you donated $1,500, that's not only dishonest, but also illegal.

Tax avoidance versus tax evasion

Some people use the terms "tax avoidance" and "tax evasion" interchangeably, but they actually have opposite meanings. Tax avoidance means taking legal steps to lower your taxes, whereas tax evasion means lying, concealing income, or utilizing similarly illegal tactics to avoid paying taxes. Common examples of tax evasion include:

  • Underreporting income.
  • Fabricating income records.
  • Intentionally underpaying taxes.
  • Claiming illegitimate business expenses or dependents on your tax return.

Another major difference between tax avoidance and tax evasion is that while the former, when done correctly, can lower your taxes, the latter can land you in jail. If you're caught concealing income or intentionally exaggerating deductions, you could face up to five years in prison and up to $250,000 in fines. Even if you're not convicted at a criminal level, you could face a civil penalty of up to 75% of the amount of tax you underpay (on top of what you originally owe). On the other hand, if you're smart about practicing tax avoidance, you won't be penalized at all, and you'll lower your taxes in the process.

Because the tax code is complex and has its share of gray areas, some tax filers inevitably cross the line from tax avoidance to tax evasion. Usually, the IRS can tell the difference between outright tax evasion and an honest mistake, and it typically won't pursue tax evasion charges unless it believes someone has willfully attempted to engage in acts of deceit. That said, the term "willful" is somewhat open to interpretation, so it pays to err on the side of caution when preparing your taxes. If you're ever in doubt, consult with a tax professional rather than take chances on your return. Saving a few dollars isn't worth the consequences tax evaders ultimately face.

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