A tax loophole is a tax law provision or a shortcoming of legislation that allows individuals and companies to lower tax liability. Loopholes are legal and allow income or assets to be moved with the purpose of avoiding taxes. This is different than lesser known tax deductions or strategies that are intentionally available for taxpayers to save money. Let’s break down how loopholes work, common examples and how they differ from intended tax-saving strategies.
What Makes a Tax Loophole?
Some tax loopholes are easier to identify than others. Individuals or companies use loopholes to move money and assets to avoid paying taxes. An American corporation, for example, moving offices and factories overseas could be doing so with the purpose of saving money on U.S. taxes.
The basic definition of a tax loophole is a provision in the tax code that allows taxpayers to reduce their tax liability. Though this definition should be expanded to include shortcomings of the law that were not obvious when legislated.
Many loopholes are unintended, meaning that they weren’t foreseen by the regulators or legislators who drafted the law. And those using the loophole, while allowed by the law, nevertheless circumvent it due to a flaw in the legislation.
Many tax loopholes are closed over time. Here are three common tax loopholes that allow individuals and companies to move assets for the purpose of avoiding taxes.
3 Examples of Tax Loopholes
The carried interest loophole: If you’re a hedge fund manager, venture capitalist or partner in a private equity firm, the carried interest loophole allows your compensation to get taxed at a much lower rate than the regular income tax rate. While someone just as wealthy as a hedge fund manager would have their income taxed at the highest marginal tax rate, a hedge fund manager’s income is taxed at the long-term capital gains rate. A hedge fund’s profits are considered carried interest realized over the long term, so they get treated as long-term capital gains. Because the income of a hedge fund manager, venture capitalist or partner in another private investment fund comes from those long-term capital gains, the income is taxed at the long-term capital gains rate.
Backdoor Roth IRAs. Under the current law, taxpayers earning over $140,000 annually are barred from contributing to a Roth IRA, which allows tax savings to grow tax-free. However, since 2010, high-income earners could circumvent this limit by converting a traditional IRA into a Roth IRA. This strategy is called a backdoor Roth IRA. Once income taxes are paid on the initial contributions and gains, retirement savings could grow tax-free without required minimum distributions (RMDs).
Foreign derived intangible income (FDII). This income is the portion of a U.S. corporation’s intangible income that comes from serving foreign markets. The White House says an intellectual property loophole was enacted by the Trump tax plan, which allows corporations to get tax breaks by moving assets abroad.
5 Tax Credits for All Taxpayers
The government has also drafted legislation that intentionally helps taxpayers save money. Unlike tax loopholes, this legislation is often drafted a part of a social safety net or a relief package that aims to stimulate the economy. Here are five common tax credits that save taxpayers money.
The saver’s tax credit: Working class Americans who manage to put together some savings can claim the Saver’s Tax Credit when they fill out their returns. It’s a tax break designed to give people an incentive to save money. This is especially important because so many people lack an emergency fund and have zero or insufficient retirement savings. The Saver’s Tax Credit is not refundable. It can reduce your tax bill to zero, but if the amount of your credit is greater than what you owe the IRS you won’t get the difference refunded to you.
Earned income tax credit: If you have a job but it’s not bringing in much income you can claim the Earned Income Tax Credit (EITC). Like any tax credit, the EITC directly reduces your tax bill by the size of the credit. Unlike the Saver’s Tax Credit, the EITC is refundable. If the amount of the EITC is greater than the amount you owe the IRS, you’ll get the difference refunded to you. The EITC has been very successful in reducing poverty among working-class families.
American opportunity tax credit: The American Opportunity Tax Credit provides a tax credit for eligible students participating in a higher education program after high school. You can get 100% of the credit on your first $2,000 of annual educational expenses and 25% of credit on the next $2,000 in expenses per student. Even if the qualifying educational expenses are more than $4,000 per year, you can only receive a maximum credit of $2,500 per year for each student for a maximum of four years. The credit is also partially refundable if the credit ultimately brings your total tax bill to $0. In this case, you may be able to receive up to 40% of the credit amount (up to $1,000) refunded to you.
Lifetime learning credit: This credit is for qualified tuition and related expenses paid for eligible students enrolled in an eligible educational institution. This credit can help pay for undergraduate, graduate and professional degree courses – including courses to acquire or improve job skills. There is no limit on the number of years you can claim the credit. It is worth up to $2,000 per tax return.
Child tax credit: This credit is designed to give an income boost to the parents or guardians of children and other dependents. The American Rescue Plan increased the credit – for 2021 only – to help filers cope with the effect of the pandemic. It applied to dependents who were 17 or younger as of the last day of that tax year. The credit was worth up to $3,600 per dependent, but your income level determined exactly how much you could get. In 2022, the credit reverted back to 2019 levels. So those who received $3,600 per dependent in 2021 now get $2,000 for the 2022 tax year. The credit phases out for wealthier families.
Tax loopholes are provisions in the tax code that allow taxpayers to lower their tax liability. These loopholes are often unintended, created by shortcomings in legislation that were not obvious when drafted. Many loopholes are closed over time. But the tax code is so complex that things will always slip through the cracks.
If you’re interested in lowering your tax burden, a financial advisor can help you take advantage of common tax deduction and strategies that have been intentionally created by legislation to benefit taxpayers.
Tips for Navigating Tax Season
A financial advisor can be a key resource in helping you figure out your taxes. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you don’t know whether you’re better off with the standard deduction versus itemized, you might want to read up on it and do some math. Educating yourself before the tax return deadline could help you save a significant amount of money.
SmartAsset has you covered with a number of free online tax resources to help you during tax season. Check out our income tax calculator and get started today.
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