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Tax loopholes are legal provisions or deficiencies that allow individuals and businesses to reduce their tax obligations. Loopholes are legal and allow you to shift your income and wealth for tax avoidance purposes. This is different from the lesser-known tax credits and strategies that taxpayers can deliberately use to save money. Let's analyze how loopholes work, common examples, and how they differ from the intended tax-saving strategy.

A financial advisor can assist you in developing a tax strategy that will reduce your tax liability while still allowing you to achieve your investing and retirement goals. Today is the best time to consult a financial advisor.

What Makes a Tax Loophole?

Some tax evasion schemes are easier to spot than others. Individuals and businesses utilize loopholes to avoid paying taxes by moving money and assets. For example, an American firm shifting headquarters and manufacturing overseas could be doing so to save money on taxes in the United States.

A tax loophole, in its most basic form, is a feature in the tax code that allows taxpayers to lower their tax liability. Though this definition should be broadened to encompass flaws in the law that were not apparent when it was enacted.

Many gaps are inadvertent, meaning that the regulators or legislators who designed the law did not anticipate them. Those who take advantage of the loophole do so despite the fact that it is permitted by law. This is due to a fault in the laws.

Over time, many tax loopholes are closed. The following are three common tax loopholes that allow people and businesses to shift assets to avoid paying taxes.

3 Examples of Tax Loopholes

The Carried Interest Loophole. If you're a hedge fund manager, a venture capitalist, or a partner in a private equity firm, the carried interest loophole permits you to pay taxes at a lower rate than the usual rate. A hedge fund manager's income is taxed at the long-term capital gains rate, rather than the highest marginal tax rate, as someone equally affluent would be.

Profits earned by a hedge fund are recognized as long-term capital gains since they are considered carried interest earned over time. Because a hedge fund manager's, venture capitalist's, or partner's income is derived from long-term capital gains, it is taxed at the long-term capital gains rate.

Backdoor Roth IRAs. Taxpayers earning more than $140,000 per year are now prohibited from contributing to a Roth IRA, which permits their savings to grow tax-free. Since 2010, high-income earners have been able to get around this limit by converting a traditional IRA into a Roth IRA, a strategy known as a backdoor Roth IRA. After paying income taxes on the initial contributions and gains, retirement savings can grow tax-free without having to take required minimum distributions (RMDs).

Foreign-derived Intangible Income (FDII). This is the portion of a company's intangible revenue that derives from supplying international markets. The Trump tax proposal, according to the White House, created an intellectual property loophole that permits firms to gain tax savings by shifting assets abroad.

5 Tax Credits for All Taxpayers

In addition, the government has proposed legislation to assist taxpayers in saving money. Unlike tax loopholes, this legislation is frequently included as part of a social safety net or a relief package aimed at stimulating the economy. Five popular tax incentives that help taxpayers save money are listed below.

The saver’s tax credit: When filing their taxes, working-class Americans can claim the Saver's Tax Credit. It's a tax advantage that encourages people to save money. This is especially crucial because so many people don't have an emergency fund and don't have enough money set up for retirement. The Saver's Tax Credit is a one-time payment that isn't refundable. It can lower your tax payment to zero, but if the amount of your credit exceeds what you owe the IRS, you will not be repaid the difference.

American opportunity tax credit: If you have a job but it doesn't pay well, you can apply for the Earned Income Tax Credit (EITC). The EITC, like any other tax credit, decreases your tax payment by the amount of the credit. The EITC, unlike the Saver's Tax Credit, is refundable. If your EITC is larger than the amount you owe the IRS, the difference will be repaid to you. The EITC has had a significant impact in reducing poverty among working-class families.

Lifetime learning credit: This credit is for eligible students enrolled in an approved educational institution who have paid qualified tuition and related fees. This credit can be used to pay for courses toward an undergraduate, graduate, or professional degree, as well as courses to learn or upgrade job skills. The credit can be claimed for an unlimited number of years. It might be worth as much as $2,000 for each tax return.

Child tax credit: This credit is intended to help parents and guardians of children and other dependents improve their financial situation. To help filers cope with the effects of the pandemic, the American Rescue Plan doubled the credit – but only for 2021. It applies to dependents under the age of 17 on the last day of the tax year. The credit is worth up to $3,600 per dependent, depending on your income level. Previously, the credit for each dependent was $2,000 per year. For higher-income households, the credit is phased off.

Bottom Line

Tax loopholes are elements in the tax code that allow taxpayers to reduce their tax burden. These gaps are frequently inadvertent, resulting from legislative flaws that were not apparent at the time of drafting. Over time, many loopholes are filled. However, because the tax structure is so complicated, something will always go between the gaps.

Smart Tip for Navigating Tax Season

A financial advisor can be a valuable asset in assisting you with your tax planning. It doesn't have to be difficult to find a qualified financial counselor. If you want to learn more and ask for assistance in availing tax deductions, get started now.

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About Our Financial Experts

Don Daves

Don is the Founder/CEO of the Diamond Advisor Group. He has over 35 years of experience helping people plan for their future.

Craig Daves

Craig is a Partner of the Diamond Advisor Group. He has an extensive background in Business Management, financial analysis, and retail sales. He started working in the financial services industry in late 1998 and has over 20+ years of experience.