When planning for the future, individuals and families often seek ways to minimize their tax liabilities. Understanding the difference between tax avoidance and tax evasion can help those interested in minimizing their tax burdens and the tax burdens on their heirs to employ strategies that comply with the law and avoid penalties accordingly.
In a nutshell, while both concepts concern efforts aimed at avoiding taxes, one is legal and the other is illegal.
Tax avoidance
Tax avoidance is the legal practice of minimizing tax liabilities through lawful means. It involves planning and structuring financial affairs in a way that reduces taxes under the tax code. For example, taxpayers may use tax deductions, credits, exemptions and tax-deferred investments to lower their taxable income. Estate planning strategies such as establishing trusts, gifting assets and making use of tax-free or tax-deferred accounts are common tools employed in the interests of tax avoidance.
Common methods of tax avoidance include:
- Contributing to retirement accounts such as 401(k)s or IRAs, which can reduce taxable income in the year the contributions are made
- Setting up trusts to help pass assets to beneficiaries with minimal estate tax implications
- Making charitable donations to qualify for deductions
These strategies are designed to reduce the amount of tax owed, and as long as they comply with tax laws, they are entirely legal. The goal of tax avoidance is to plan ahead to minimize taxes, which is considered a smart and responsible way to manage one’s financial affairs.
Tax evasion
By contrast, tax evasion involves illegal practices that intentionally deceive the government to avoid paying taxes owed. Tax evasion includes failing to report income, underreporting earnings, inflating deductions and/or hiding money in offshore accounts. Unlike tax avoidance, tax evasion violates tax laws and can result in severe penalties, including fines and imprisonment.
While tax avoidance is a legal and prudent way to minimize taxes, tax evasion is a crime that can lead to serious legal consequences. Understanding the difference between the two is important for those who need to engage in estate planning, in addition to those who simply want to minimize their tax liability overall.