Tax Avoidance vs. Tax Evasion

“The avoidance of taxes is the only intellectual pursuit that carries any reward.” John Maynard Keynes

There’s nothing wrong with you wanting to pay less in federal, state and local taxes. Where you can run afoul of tax regulations is how you go about decreasing your tax obligation. There are legitimate tax avoidance steps you can take to maximize your after-tax income. But, failing to pay or deliberately underpaying your taxes is tax evasion and it’s illegal.

The U.S. federal income tax system is based on the idea of voluntary compliance. Under this system, it is the taxpayer’s legal responsibility to report all income.

Tax evasion is illegal and is punishable under law

Tax Evasion—The failure to pay or a deliberate underpayment of taxes. Internal Revenue Service

A taxpayer who intentionally hides income— by lying, concealing information, or committing fraud — has committed a willful act known as tax evasion, explained Jo Willetts, Director of Tax Resources at Jackson Hewitt. Tax evasion is illegal and carries serious criminal and civil consequences.

According to the Internal Revenue Service (IRS), one way that people try to evade paying taxes is by failing to report all or some of their income. Sometimes people do not report income gained through illegal activities such as gambling and selling stolen goods. Other times they do not report all the tips they collect or the money they earn through legal activities such as garage sales, baby-sitting, tutoring, or yard work.

Common examples of tax evasion include non-reporting or underreporting of:

Overseas income;
Cash-in-hand payments for jobs like babysitting, catering, cleaning, or manual labor;
Income from side gigs;
Income from illegal activities
Gains made on digital currencies like Bitcoins; and
Payments received from a cash business like tutoring, pet sitting, or childcare.

Tax evasion can also include things like overstating deductions or failing to file a tax return.

Tax avoidance or minimizing your tax obligation is legal and encouraged by IRS

Tax Avoidance—An action taken to lessen tax liability and maximize after-tax income. Internal Revenue Service

Minimizing your federal, state and local taxes is perfectly legal and encouraged. Minimizing your taxes is about managing and structuring your finances in a way that complies with the tax code, while at the same time, lowering your total income tax.

IRS regulations allow eligible taxpayers to claim certain deductions, credits, and adjustments to income. Essentially, these provisions have been built into the tax code to influence taxpayer behavior.

For instance, to encourage home ownership, an interest deduction is available for eligible homeowners with a mortgage. To make it easier for primary caregivers to get back to their job and career, working parents could potentially qualify for a credit for childcare expenses. To promote financial protection for families, death benefits from a life insurance policy is exempt from taxes.There are also deductions based on the number of family members.

These are only a few of the many ways people can legally limit the tax they pay. However, the taxpayer must be able to prove that he or she qualifies. Many people pay more federal income tax than necessary because they misunderstand tax laws and fail to keep good records.

In reality, most taxpayers are already engaging in some form of tax minimization. For example, if you contribute to an employer-sponsored retirement plan with pre-tax funds, that is a tax-minimization strategy because (1) you’re deferring a tax payment, and (2) you will likely pay less tax when the funds are withdrawn in retirement.

The most common and effective tax planning strategies include:

Contribute a 401(k) or IRA: The money people put into their 401(k) or IRA the IRS does not tax until it’s withdrawn. Many employers offer a 401(k) option with a matching contribution to help boost their employees’ retirement funds.
Revise W-4 withholdings: Most people have their income tax withholdings set to a standard amount for their tax bracket. Every financial situation is unique. Therefore, consider revising how much money is paid to the IRS to reduce tax liabilities later.
Use FSAs and HSAs: With flexible spending and health savings accounts, individuals can contribute to a dedicated account for their medical expenses. This money is specifically for medical care, so it is added to an account pre-tax.

Ultimately, investing money into financial tools that offset taxes can be a significant advantage for both long-term investment and tax planning strategies. The IRS offers a variety of opportunities for people and businesses to reduce their tax liabilities.

Additionally, the most practical IRS tax avoidance methods include:

Itemization: Depending on how much an individual or couple’s expenses are every year, it might be more lucrative to itemize tax deductions. It can be time-consuming and requires diligent recordkeeping, but it’s especially valuable for anyone with mortgages or expensive medical bills.
Tax credits: A tax credit, which is different from a deduction, gives money back to individuals and families. These credits generally come with stipulations. However, these credits can be worth the investment for people with big tax bills.
Tax deductions: Tax deductions are another way to reduce tax liabilities. With a deduction, someone’s taxable income gets reduced, which lowers the total amount owed to the IRS. Popular tax deductions include work-related expenses, property, and real estate taxes, and contributions to charity.

Tax avoidance or minimizing your federal taxes through the IRS can be one of the most critical tools for individuals, families and small businesses that don’t have access to tax-reducing investment strategies.

In summary, tax avoidance is the practice of using legal means to minimize your tax burden. Tax evasion, on the other hand, is using illegal means to hide or under report income from the IRS, or take deductions you aren’t actually allowed.

“Congress can raise taxes because it can persuade a sizable fraction of the populace that somebody else will pay.” Milton Friedman

References:

From Gratitude to Greatness: Brownlee Global's Path to a Purposeful Life

Guide and Educate Individuals How to Build Long-Term Wealth, Better Manage Their Money, and Achieve Financial Freedom

Like this:

Related