Tax Avoidance vs. Tax Evasion

Angie, a software engineer, frequently adjusts her 401(k) contributions, sometimes reaching the maximum annual limit. She claims these contributions as a deduction on her taxes.

• Legal - Tax Avoidance

• Illegal - Tax Evasion

Answer explanation

Legal: Angie uses a 401(k) to reduce her taxable income. The IRS allows yearly contributions up to a limit, which can be deducted on tax returns.

Stephen works as a server at a local restaurant where he receives cash and credit card tips as part of his income. At the end of his shift, he chooses to report his credit card tips, but not his cash tips.

• Legal - Tax Avoidance

• Illegal - Tax Evasion

Answer explanation

Illegal: All tips, whether received via cash or credit card, are taxable income and must be reported. Failure to report all tips is a deliberate underreporting of income.

Brooke donates money to a non-profit organization and reports a tax deduction for the amount of her charitable contribution.

• Legal - Tax Avoidance

• Illegal - Tax Evasion

Answer explanation

Legal: The IRS lets taxpayers deduct donations to qualified nonprofits. This  reduces taxable income while supporting charities.

Jacob, a freelance writer, uses a specific area in his home for his business. He claims a deduction on his tax return for expenses related to this part of his home.

• Legal - Tax Avoidance

• Illegal - Tax Evasion

Answer explanation

Legal: The IRS allows home office deductions if the space is exclusively and regularly used for business. Jacob meets this rule and claims the deduction.

Katie, a small business owner, claims her personal grocery expenses as an operational expense for her business on her tax return.

• Legal - Tax Avoidance

• Illegal - Tax Evasion

Answer explanation

Illegal: The IRS prohibits claiming personal expenses as business expenses. Only valid business expenses can be deducted.

Jimmy has a high-deductible health insurance plan and makes sure to contribute the maximum amount each month in an effort to lower his taxable income.

• Legal - Tax Avoidance

• Illegal - Tax Evasion

Answer explanation

Legal: Contributing to a high-deductible health insurance plan's HSA is a government-approved strategy to lower taxable income. HSAs are designed to offer tax advantages for saving money for medical expenses.

Byron and Alexis open a 529 college savings account for their daughter's education. The earnings in this account are not reported on their taxes.

• Legal - Tax Avoidance

• Illegal - Tax Evasion

Answer explanation

Legal: Earnings in a 529 plan are tax-free when used for qualified education expenses, offering a tax-advantaged way to save for education.

Kevin donates $10,000 to a charitable organization in addition to volunteering from time to time. He reports the $10,000 donation, plus an additional $5,000 (what he would have made at his job if he wasn’t volunteering) on his taxes.

• Legal - Tax Avoidance

• Illegal - Tax Evasion

Answer explanation

Illegal: A $10,000 cash donation to charity is deductible, but personal time or services are not. Misreporting volunteer time as a donation is fraud.

Samantha has a variety of investments, including stocks, bonds, and mutual funds. Each year, she receives numerous statements about dividends and capital gains. She meticulously reports her largest gains, while omitting smaller gains or losses because they don’t significantly impact her investment income.

• Legal - Tax Avoidance

• Illegal - Tax Evasion

Answer explanation

Illegal: Taxpayers are required to report all investment income, including dividends, interest, and capital gains. Failing to report all income accurately to the IRS is a violation of tax laws.

Alex recently upgraded his home with energy-efficient windows and solar panels. He claims a credit on his tax return, reducing his tax liability.

• Legal - Tax Avoidance

• Illegal - Tax Evasion

Answer explanation

Legal: A tax credit for energy-efficient home improvements reduces tax liability and promotes energy conservation.