Understanding tax loopholes
Explore everything you need to know about tax loopholes, including how they’re used to avoid taxes and what forms they commonly take.
What is a tax loophole?
Properly utilizing a legal tax loophole can lessen your financial burden and put more money back into your pocket. But what is a tax loophole?
A tax loophole is either a gap or a provision in line with tax law allowing individuals to reduce their overall tax liability. It’s often described as a form of tax avoidance, which is legal and defined by the IRS as “an action taken to lessen tax liability and maximize after-tax income.” This is distinct from tax evasion, which is illegal and defined by the IRS as “the failure to pay or a deliberate underpayment of taxes.”
Tax loopholes are one option, but you can utilize other tax avoidance methods, including tax credits, tax deductions and certain forms of income exclusion.
Many tax loopholes are unintended and unforeseen by lawmakers and will eventually be closed by future legislation. In the meantime, however, proper use of these loopholes could allow you to reduce your tax burden.
Examples of common tax loopholes
Having defined the true meaning of a tax loophole, let’s now look at some examples of tax loopholes that are regularly utilized in the US:
1. Backdoor Roth IRAs
Backdoor Roth IRA is a term used to describe how high earners get around Roth IRA (Individual Retirement Account) income limits. Single taxpayers who earn above $153,000 annually or couples filing jointly who earn above $228,000 annually can’t contribute directly to a Roth IRA.
They can, however, contribute to a traditional IRA and then convert it into a Roth IRA from there, allowing them to enjoy tax-free retirement withdrawals without any mandatory distributions.
2. Carried interest
Hedge fund managers, private equity firms, and venture capitalists can benefit from lower taxation rates by exploiting the carried interest looping. As the income of these parties comes from carried interest earned over the long term, they are taxed at the capital gains rate rather than the standard income tax rate.
Even if they’re earning enough in a given year to be taxed at the top marginal income tax rate of 37 percent, this will allow them to be instead taxed at the much lower long-term capital gains tax rate of 20 percent.
3. Life insurance
A permanent/whole life insurance policy builds cash value, and that value can grow tax-free for as long as you leave it in your account.
When you die, your beneficiaries can receive that cash value free of income tax. Plus, even while you’re still alive, you can use this type of life insurance policy as a tax loophole by borrowing against the cash value. This loan, again, will be tax-free, though you’ll still need to pay it back with interest.
How do rich people avoid taxes?
Citing academic researchers, the US Department of the Treasury claims that more than $160 billion in tax revenue is lost each financial year due to tax avoidance practices implemented by the country’s richest one percent of taxpayers. That’s no small number. As you’ll have seen from the above, most tax loopholes favor or more strongly benefit the rich.
On top of those loopholes, though, very wealthy people tend to have many other tax-reducing tactics in their arsenal. These tactics include:
Borrowing money – banks and lenders are far more likely to lend to rich people, so they will often opt to take out huge loans to fund their lifestyles rather than selling anything taxable and having to foot that additional bill.
Making charitable donations – donations of cash and property to eligible charitable organizations are tax deductible if itemized. Usually, you can deduct up to 60% of your AGI (Adjusted Gross Income).
Creating family partnerships – family-limited partnerships can reduce estate taxes by limiting the assets considered part of the estate and put through the probate process. This is only valuable to those with highly sizable estates to pass on.
Gifting – to reduce estate taxes upon death, many older individuals with a lot of money choose to use the annual gift tax exclusion to their benefit. This exclusion was $17,000 or less per person in 2023.
Investing – income earned from investments is often tax-beneficial, especially if you can afford to hold onto an investment for over a year. You’ll be taxed in the long term at a capital gains rate from 0–20 percent.
Relocating to another state – if a person with money to spare is genuinely committed to limiting their tax liability, they may choose to relocate to one of the handful of places in the US with no income tax levied at the state level.
What tax liability reduction methods are available?
Though many traditional tax loopholes and similar tactics don’t work for people who aren’t incredibly well-off, this isn’t the end of the story. There are still ways for average and lower-income US taxpayers to reduce their burden.
We’ve already touched on tax credits and deductions, two types of tax avoidance that can work alongside tax loopholes. To offer some more detail:
Tax credits – tax credits are added to your tax return to reduce the final amount of tax you owe. Examples include the Child Tax Credit, the Lifetime Learning Credit and the Earned Income Tax Credit for low- and moderate-income families.
Tax deductions – tax deductions reduce the income you’ll report when filing your return, reducing the amount of tax you’ll owe. Examples include the Standard Deduction and the Mortgage Interest Deduction.
Let’s take the Earned Income Tax Credit as an example. Thanks to this credit, low-income and moderate-income families can receive the following maximums for their children (the maximum for families with no children is $560):
$6,935 for three or more qualifying children
$6,164 for two qualifying children
$3,733 for one qualifying child
Regardless of the specifics of your financial situation and the level of personal wealth, you have to your name, the best thing you can do is seek an informed expert's advice concerning tax liability and potential tax burden reduction. Nobody is better equipped than a financial advisor to minimize that burden.
We’re ready and waiting to provide that support. Find a qualified, experienced advisor who can meet all your financial planning needs today.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.