What is a tax loophole and how does it work?

Summary

What is a tax loophole?

A tax loophole usually arises from an omission, ambiguity, or exception to a certain aspect of the tax code, the set of rules that dictate how much money you are due to pay the government each year.

Exploiting tax loopholes is not unlawful. However, because loopholes tend to be quirks resulting from the unintended consequences of legislation, they are not guaranteed to exist forever.

This means that loopholes can always be amended or closed, which would shut down any benefits that had previously slipped through the tax net.

That said, a suitably qualified financial advisor should be able to identify tax loopholes from which you are currently able to benefit and incorporate them into your financial planning needs.

What is the difference between tax avoidance and tax evasion?

There is, however, a major distinction between tax avoidance and tax evasion, and it’s worth being aware of the difference.

Tax avoidance involves utilizing so-called tax loopholes to reduce an individual’s or a business’s tax liability.

In stark contrast, tax evasion is illegal and involves dubious methods, such as concealment and deceit, to pay less tax than is due.

For example, it involves under-reporting or omitting income, falsifying deductions, or claiming personal expenses as business expenses.

Tax evasion is a serious offense that can result in a fine, imprisonment, or both.

When is a loophole, not a loophole?

As well as a handful of tax loopholes, there are numerous tax breaks - in the form of credits, allowances, and deductions - that can also help to bring down your tax liability.

These tend to be benefits offered by the authorities that are free from grey areas.

Tax breaks are directed at broad groups of taxpayers, with the aim of providing financial relief in various areas - everything from childcare and owning an electric vehicle to education and personal investing.

In this sense, tax breaks differ from tax loopholes, although the term "loophole" is commonly used as a blanket term for all tax reduction opportunities.

Before looking at tax breaks, let’s start by considering some actual tax loopholes.

What are examples of tax loopholes?

Now that we’ve defined what a tax loophole is, let’s explore some common examples used in the US:

1. Backdoor Roth IRAs

As with all individual retirement accounts (IRAs), Roth IRAs allow you to potentially grow your savings through investments while receiving specific tax benefits.

With these plans, you do not receive an upfront tax deduction, as is the case with "traditional" IRAs, 401(k) retirement plans, or other "tax-deferred" accounts. Instead, you pay after-tax dollars into the account where the earnings accumulate tax-free.

Technically, however, Roth IRAs are only available to those whose modified adjusted gross income, or MAGI, falls below certain limits. MAGI is a calculation that works out your overall taxable income figure once considerations such as interest payments and expenses have been taken into account.

In 2024, the MAGI limits for Roth IRAs were $240,000 for married couples filing their tax paperwork jointly and $161,000 for single filers.

However, it is possible for higher earners to side-step these earnings limits, using a so-called “backdoor” route.

This is done by opening and contributing to a traditional IRA using after-tax dollars and then converting - or “rolling over” - these funds into a Roth IRA using a two-step process.

Despite this strategy having been in existence for more than 20 years, there is no formal guidance from the Internal Revenue Service about whether the conversion process sits entirely within the rules nor whether the backdoor Roth IRA option will stay around forever.

On top of this, deciding whether to convert to a Roth IRA depends on your personal financial circumstances, as it’s not an option that would work for everyone. A financial advisor specializing in tax would be able to guide you through the potential advantages and disadvantages of choosing this route.

2. Carried interest loophole

This loophole is of special relevance to those working in niche areas of the financial services industry, such as private equity, venture capital, and hedge funds.

Private equity firms raise money from large collective financial arrangements, such as insurance funds, to invest in companies. As part of the process, they often take control of those businesses.

Having successfully completed a transaction - for example, by eventually selling on a company for more than they paid for it - private equity executives typically receive a share of the profits, known as “the carry,” for having managed those investments.

If such an asset is sold after three years, the profit is taxed at the long-term capital gains tax rate of 20%. Before three years, a short-term capital gains tax rate of 37% is levied.

The key point here is that the 20% tax rate on so-called carried interest, as the profits are referred to, is lower than that paid by many everyday US workers.

For example, a couple filing jointly with an income under $200,000 face a 22% tax rate, according to 2024 figures, while a single person earning under $192,000 is levied at 24%.

3. Life insurance loophole

Due to the way they are designed, whole life insurance plans last the entire duration of an individual’s life and guarantee a payout when the policyholder eventually passes away.

Whole-life policies have a fixed premium, which tends to be more expensive than the cost of term insurance plans, which only last a stipulated amount of time. A savings component is also included in the design of a whole-life policy.

While part of your annual whole-life premium covers the cost of insurance, the balance is invested in a pool of conservative, typically fixed-income investments overseen by the insurance company providing the plan. This element is referred to as the policy’s “cash value.”

If a whole life plan has been running for several years, its cash value can be considerable. The amount can also be used for various purposes, including borrowing against it.

The insurer will charge interest on the loan at a rate stipulated by the policy contract. Crucially, the withdrawal will count as a loan free of income tax.

Should the loan never get paid back, the death benefit paid out at the eventual time of the policyholder’s death will be reduced by the unpaid amount and any remaining loan interest.

What credits, allowances, and deductions can be used to reduce tax?

Tax credits and tax deductions are often grouped under the blanket heading of "loophole" although, strictly speaking, there is less ambiguity about their status. Tax break is a more accurate description.

The good news is that, as the following list confirms, there are a large number of tax breaks touching on different aspects of our day-to-day lives.

Tax credits and deductions available to US citizens include:

Bear in mind that while a tax credit is designed to reduce how much you owe in taxes, a tax deduction, by way of contrast, reduces your taxable income.

How can you reduce your tax bill?

In addition to tax breaks, several other strategies can help optimize your tax planning - from education to preparing for retirement:

In addition to potentially beneficial gaps in the tax system, there are plenty of other areas where you can optimize your finances with a view to keeping tax bills down and maxing out on entitlements you might be due.

To understand what is rightfully yours, start by establishing the fundamentals, such as your federal tax bracket.

In the US, people with higher taxable income are subject to higher rate taxes, while people with lower taxable incomes are subject to lower rates.

There are seven federal income tax brackets, namely: 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

Keeping track of your financial transactions and remembering to date and itemize them will also help you complete tax paperwork.

Remember, also, that your work location can affect your tax status. Remote working is now common for millions of workers, so it’s worth considering the tax implications if you live in a different state from where your employer is based.

States differ in their definitions of "residency," which can. These include domicile in the state, maintaining a non-temporary presence in the state, or having a presence for a distinct period of time.

As a rule of thumb, if you work remotely in a state for 183 days of the year, that state may regard you as a resident and tax your total income.

If it’s relevant, keep track of the days you spend working in different locations. Consider consulting a tax advisor about the latest rules in the states where you’re living, where you’re working remotely, and where the business is located.

These dedicated savings accounts are aimed at helping people save for college. They can offer tax-free investment growth and withdrawals for qualifying educational expenses and are offered by most states and some academic institutions.

They don’t allow you to deduct contributions from your federal income taxes, but you might be able to reduce the liabilities on your state return if you contribute to your state's 529 plan.

Your employer might offer a 401(k) savings and investing plan that provides you with a tax break on the money you put away for retirement. Similarly, contributions to a traditional IRA may be tax deductible.

Both Health Savings Accounts (HSAs) and Health Flexible Spending Accounts (health FSAs) could allow you to squirrel away tax-deductible or pre-tax contributions for certain medical expenses that your health insurer does not cover.

Investing in areas such as the stock market is not for everyone. That decision should be based on your personal circumstances, financial needs, timeline and attitude to risk. Although not appropriate for all, it’s worth being aware that some investments are more tax-friendly than others.

Municipal bonds, for example, are a type of investment vehicle offering diversification benefits and a steady income stream. They can be bought through brokerage accounts, either individually or as part of a mutual or exchange-traded fund.

As a general rule, the interest from municipal bonds is exempt from federal income tax and, in some states, from state and local taxes.

Bear in mind, however, that if your MAGI is at least $200,000, you’ll be subject to a 3.8% Net Investment Income Tax on either your net investment income or the amount your MAGI exceeds the statutory threshold amount, whichever is less.

How do the rich avoid taxes?

According to US Treasury estimates, the top 1% of Americans underpay their taxes by about $160 billion each year. Again, they aren’t necessarily using loopholes to do this. Rather, they make the most of what the rules allow in a number of areas.

For example, they create foundations, set up family offices (to manage their wealth), change their residency status (potentially by moving abroad), benefit from the depreciation in real estate prices, as well as gifting their wealth away using favorable tax allowances.

Most of these strategies are out of the reach of the ordinary citizen.

The rich also use tax laws to offset their investment losses against other gains they may have made. This approach can potentially appeal to personal investors of all stripes.

Get expert financial advice

Life events rarely run in a straight line, and taxation laws change periodically, along with the politicians and governments that impose them.

It’s worth taking time to regularly review your financial and tax situation to make sure you are holding on to as much of your wealth as is legally allowed and also to be aware of what upcoming changes to the rules could mean for your status.

To help with this, it may be worth hiring a suitably qualified financial advisor who is aware of existing and forthcoming tax legislation and can prepare a plan to keep your arrangements in optimal financial shape.

Unbiased can match you with a financial advisor best suited to meet your needs.