With the arrival of 1099s and W-2s from your employer, banks and others, it's time to get down to the business of filing your income tax return. While technology has certainly eased the burden of filing, mistakes still happen. This article focuses on some of the more common mistakes that will cost you money.
Despite the explosion of electronic filing solutions, math errors are still the taxpayerÂÂÂ’s No. 1 problem. While most common for those who file old-fashioned paper forms, even computer-prepared returns can be incorrect if the preparer transfers the wrong number from one schedule to another.
IRS computers are adept at catching these errors. If your return is wrong and you owe more taxes, you will get a bill for the tax, plus penalties and interest. If you owe less, you will get a check from the IRS.
Don't assume that the IRS calculations are correct either. Even they make mistakes sometimes. Take a good look at the numbers before you pay any bill.
Interest and Dividends
If you earn interest or dividend income, make sure you include it on your return. The IRS matches the income on your return to the amount reported by payers. This results in about 10 million notices annually, including a number of which are incorrect. Unfortunately, fear of the IRS leads many taxpayers to simply pay the notice without investigating its validity. Depending on the amount, this can be a reasonable course of action. However, if you believe the IRS is wrong, follow the prescribed procedures to contest the assessment.
Incorrect Investment Basis
Whenever you sell an investment, you pay tax on the proceeds less your basis. Basis is generally the original cost of the investment, plus any dividends or other income reinvested, less prior sales. In the case of mutual funds and stocks, it can be tricky to calculate the basis for investments held for many years. Here is an example: You purchase Mutual Fund A for $1,000. At the end of the year, the Fund declares a dividend of $100. You will pay tax on that $100, but your basis will also increase. If you sell half of your shares the next year for $1,000, you will recognize a taxable gain of $1,000 minus half of $1,100, which comes out to $450.
It is not unusual for a client to provide the original cost of the investment but fail to share information on dividends, sales and other events that affect the basis of the asset. This can literally mean the difference between taxable income and a loss.
Failure to Report Stock Sales
In a rush to file for a refund, taxpayers might forget to wait for Form 1099-B, which brokers file with the IRS to report sales of stocks, bonds and other investments. Unfortunately, the IRS will compare the amount reported by the payer to your tax return. If you have not reported a stock sale, the IRS will send you a bill for tax on the entire amount of the sale. Should this happen, do not send a check to the IRS. It is probable that you have some basis in the asset that can be used to reduce taxable income or even totally eliminate it.
A Final Word on Stock Basis
Until 2010, if you inherited property, your basis in the property equaled its value on your benefactor's date of death. For example, your mother bought $10,000 worth of Exxon stock on Jan. 30, 1970. She died on Dec. 15, 2009. Six months later, you sell the stock for $1 million. The closing price on Dec. 15, 2009, was $69.17, making the value of the stock your mother gave you about $393,000 when she died.
Heirs sometimes refer to the original cost basis of inherited property when reporting the gain or loss from the sale of property. If this happened in the example above, the heirs would incorrectly pay tax on $990,000 in capital gains and not $607,000.
We often see cases where a spouse dies and the survivor provides us with the original cost basis of stock. If the stock is community property, the basis of all the stock in the community is the value on the spouse's date of death.
Change in Marital Status
With some exceptions, your marital status on Dec. 31 dictates your filing status for the year. Marrying on Dec. 31 might sound romantic, but it can have serious tax consequences. While Congress addressed the marriage penalty several years ago, many tax provisions still work against you if you marry at the end of the year. In some cases, spouses who decide to file as married but on separate returns lose the entire benefit of tax breaks. The reverse is also true.
The bottom line is this: before taking the plunge or ending your marriage, do the math. If a change in marital status by year-end costs you money, postpone the event by a few days. Even if you donÂÂÂ’t change the big date, at least youÂÂÂ’ll know what it will cost you.
Keep Up With Your Receipts
If you take a deduction, the IRS might ask you for proof of that deduction in the form of a receipt. No receipt means a lost deduction. Typically, the IRS has up to three years from the date your return is filed to adjust it, unless fraud can be proven. Since a disallowed deduction will increase your tax, by the time you get the bill from an audit added penalties and interest will significantly increase the amount you owe.
Improperly Paying Itemized Deductions
Many taxpayers do not pay enough in a given year to exceed the standard deduction. With a little timing, though, you can realize significant tax savings by bunching itemized deductions.
For example, say you are married, file jointly and typically give $10,000 to your favorite charity every year on Dec. 31 and this is your only itemized deduction. For 2009, the minimum you can deduct regardless of your actual itemized deductions is $11,400. If you follow your typical pattern and give $10,000 on Dec. 31, 2009, 2010 and 2011, your deductions for 2009, 2010 and 2011 will be $11,400. If, however, you wait to make your 2010 donation until 2011, you will deduct $11,400 in 2009, $11,400 in 2010 and $20,000 in 2011, resulting in significant tax savings.
Failure to Pay Estimated Taxes
If you are required to make estimated tax payments, failure to do so will cost you money. Certain taxpayers are required to make quarterly estimated tax payments during the year in anticipation of their year-end tax liability. This is in addition to or in lieu of withholdings from your paycheck. If you fail to make the required payments, you will owe an estimated tax penalty. Depending on the required payments, those penalties can be significant.
Failure to Properly Extend a Return
Many taxpayers fail to extend their returns on the April 15 due date. Sometimes this is accidental, but some taxpayers will not extend because they believe they must send a check with the extension. Even if you can't make an extension payment, the penalty for failure to file your return on time is 5 percent of the tax due multiplied by the months you delayed filing. The late payment penalty is 1.5 percent per month. Lower those costs by extending, even if you cannot pay.
The Bottom Line
The tax law is complicated and there are numerous traps for unsuspecting taxpayers. Before you file this year, consider this list of common tax return errors and do your best to avoid them. If you have any questions, give us a call. We will be glad to help.