What is a tax loophole and how does it work?
A tax loophole is a legal way to reduce taxes using provisions in the law. We'll explore how they work and common examples to help lower your tax burden.
What is a tax loophole?
A tax loophole is a legal way to reduce the amount of taxes you owe, putting more money back in your pocket. But what exactly is a tax loophole?
A tax loophole refers to a gap or provision in tax law that allows individuals to lower their overall tax liability. It’s considered a form of tax avoidance, which is completely legal. According to the IRS, tax avoidance is “an action taken to lessen tax liability and maximize after-tax income.” This is very different from tax evasion, which is illegal and defined by the IRS as “the failure to pay or a deliberate underpayment of taxes.”
Besides loopholes, there are other legal ways to avoid paying more taxes, such as using tax credits, deductions, or excluding certain forms of income.
Many tax loopholes happen unintentionally due to gaps in lawmaking, and lawmakers may close these in the future. However, for now, taking advantage of them can help reduce your tax burden.
Six tax loophole examples
Now that we’ve defined what a tax loophole is, let’s explore some common examples used in the US:
Here's an expanded version of the list, keeping the original depth and detail:
1. Backdoor Roth IRAs
High-income earners who exceed the income limits for direct Roth IRA contributions—$153,000 for single filers or $228,000 for joint filers—can use a "backdoor" method. They contribute to a traditional IRA and then convert it to a Roth IRA, allowing for tax-free withdrawals in retirement without mandatory distributions, bypassing the income limits that otherwise apply.
2. Carried Interest
Hedge fund managers, private equity firms, and venture capitalists can use the carried interest loophole. Instead of paying the regular income tax rate of up to 37%, their earnings from carried interest are taxed as long-term capital gains, which are typically taxed at a lower rate of 20%. This is a significant tax-saving opportunity for those working in high-paying investment roles.
3. Life Insurance
Permanent or whole life insurance policies build cash value over time, which grows tax-free. When the policyholder dies, beneficiaries receive the death benefit free of income tax. Additionally, while alive, the policyholder can borrow against the cash value without paying taxes on the loan. However, they must repay the loan with interest, but it remains a tax-efficient method of accessing money.
4. Capital Gains Tax vs. Income Tax
When you sell property or investments at a profit, you pay capital gains tax rather than regular income tax. Capital gains are typically taxed at lower rates (15% or 20%) compared to regular income. For example, in 2020, the top income tax rate was 22% for many individuals, but capital gains were taxed at just 15%. By focusing on capital gains instead of earning a salary, you can significantly reduce your tax liability.
5. Employer-Provided Health Insurance
If your employer provides health insurance, the value of that benefit is not included in your taxable income. This creates a tax advantage, especially when choosing between jobs. For example, opting for a position with slightly lower pay but comprehensive health insurance could mean lower taxable income and the added benefit of not having to purchase health insurance out-of-pocket.
6. 529 College Savings Plan
A 529 plan allows you to save for your child’s college expenses in a tax-advantaged way. Money placed into a 529 account grows tax-free, and withdrawals used for qualified education expenses are also tax-free. Additionally, contributions to a 529 plan may offer state tax benefits, reducing your overall tax liability while helping fund future education costs.
These examples highlight different ways to legally minimize your tax liability through careful financial planning and taking advantage of specific tax provisions.
These examples show how different tax loopholes are used to reduce tax liability.
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.
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%.
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
Get expert financial advice
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.