We all want to pay less less, but what’s legal and what’s illegal? There are three basic strategies to pay less taxes and keep more of your money — tax avoidance, tax deferral, and tax evasion. Two are perfectly legal, but practicing one of them could lead to some serious jail time.
Although they all sound similar, they’re actually very different endeavors with different procedures.
Let’s look at all three methods of how to keep your tax bill at a minimum, and dive into the specifics of each.
1. Tax Avoidance
Tax avoidance is the use of perfectly legal methods of minimizing your income tax liability. It involves declaring all income, but maximizing any available deductions and credits.
On the topic of tax avoidance, the U.S. Supreme Court has even declared it is “The legal right of an individual to decrease the amount of what would otherwise be his taxes or altogether avoid them, by means which the law permits, cannot be doubted.” This is to say you aren’t required to pay more in taxes than the law prescribes.
Given that the word “avoidance” might be construed as some sort of dodge, tax avoidance might better be stated as tax minimization. The idea — widely practiced by both individuals and tax practitioners — is to use every means legal and necessary to reduce the amount of taxes you owe.
Examples of tax avoidance methods include:
- Making an IRA contribution to lower your taxable income
- Using a Subchapter S corporation format in your business in order to reduce the amount of income subject to Social Security and Medicare taxes
- Appealing to the local municipality or county tax authorities to have the value of your property lowered, which lowers your real estate taxes
- Taking advantage of tax credits (which directly reduce your tax liability) for installing energy-efficient component systems in your home
- Deducting expenses used in connection with your investment activities
- Choosing to buy a home, rather than rent, because of the generous deductions connected with mortgage interest and real estate taxes
- Choosing to hold capital assets for more than one year, to take advantage of lower long-term capital gains tax rates
This is just a small sampling of tax avoidance strategies, all of which are perfectly legal. Tax avoidance is probably the single biggest reason for the existence of CPAs and tax attorneys. They are professionals who are specifically familiar with tax avoidance strategies, and they can command serious fees for the work they do.
2. Tax Deferral
If tax avoidance is about lowering your overall tax liability, tax deferral focuses on shifting your income into future years. The presumption is you’re moving income from the present — when your income is being taxed at high rates — to some time in the future, when you will be taxed at much lower rates.
The most popular example of this is tax-deferred retirement plans, including IRA, 401(k), and 403(b) plans. These plans lower income tax liability through two primary methods:
- Allowing you to reduce your present level of taxable income, and
- Allowing the money placed in such accounts to accumulate investment earnings, without regard for income taxes, until the time of withdrawal
Both of these methods represent the deferral of income tax liability from the present until the future. It is generally assumed your tax liability will be substantially higher during your working years than it will be in retirement.
For example, you may be in the 28% federal income tax bracket right now, but by the time you retire you may only be in the 15% bracket. You will be saving taxes at 28%, but subject to it later at only 15%. Making the deferral even more effective is the fact that some states either exempt retirement income from taxation, or tax it at more favorable rates.
There is also the advantage in tax deferral that investments grow much more quickly when they’re not subject to income taxes in the years earned. This allows the investments held in a tax-deferred retirement plan to grow much more quickly than they would in a taxable plan.
And like tax avoidance, tax deferral is perfectly legal and widely practiced. So be sure you’re taking full advantage of the deductions you legally deserve.
3. Tax Evasion
Generally speaking, tax evasion is the result of seeking to reduce or eliminate tax liability by illegal means. Typically this includes either knowingly under-reporting income, or failing to show any income at all. In extreme cases, this can take the form of elaborate subterfuges used to hide income, including the use of unrelated accounts to deposit income, or accepting payment primarily in cash.
Tax evasion can also take the form of either over-stating tax deductions, or even creating them out of thin air. In this scenario, the taxpayer may fully declare all income received, but offset it, either substantially or entirely, with completely bogus tax deductions.
Tax evasion is a practice that always results in financial penalties, and sometimes rises to the level of criminal prosecution, which can include both heavy fines and incarceration. We are not recommending this method to minimize your taxes, but only want to clarify the difference of each method.
As a taxpaying citizen, it’s important to know and understand all three methods used to pay less taxes. It’s also important to know which are legal, and which can get you into big trouble.