Tax and Financial News for February 2012

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Should You File a Tax Return?

We have been asked on many occasions whether a client or someone they know should file an income tax return. You might think the answer to that question is easy, but certain circumstances make the question more difficult to answer. This article is intended to shed a little more light on the question.

The instructions to Federal Form 1040 provide you with a fairly comprehensive listing of circumstances in which you are required to file a tax return. These include situations where your gross income exceeds a set minimum, depending on your filing status; and whether you owe any special taxes, including but not limited to alternative minimum tax, any penalty on premature distribution from a retirement account, recapture of the first-time home buyer credit and other situations.

We can’t tell you how many times people have come to us for help after failing to file their income tax returns. Their incentive to finally file past due returns is generally a not-so-gentle letter received from the IRS claiming significant taxes, penalties and interest. The first words that come out of most taxpayers’ mouths are, “My withholdings were higher than what I thought I owed, so I didn’t worry about it.” While this can seem like a good answer, taking this approach can cost far more in the long run than if the filing had been done in a timely manner.

For example, say you are a single mother with three qualifying children and your only income in 2010 was a salary of $25,000. You had no other taxable income, although your ex-husband did pay $3,000 a month in child support. You federal withholdings amounted to $2,094. Since you are so busy you can’t even think straight, you forget to file your return.

On the way to work on Oct. 15, you hear a public service announcement reminding everyone that today is the last day to file income tax returns and not get penalized. That has you worried since you are certain you can’t find the time to get to the tax office and file the return. When your co-workers ask what the problem is and you tell them you are worried about taxes, they tell you not to worry; after all, you paid in enough that the IRS won’t care if you forget to file. You stop worrying and the problem drops off your radar screen.

Unfortunately, you have just lost a lot of money. Here is why: aside from the potential of getting threatening letters from the IRS, had you prepared the return – assuming none of the available credits – you would have received a refund of approximately $1,900. However, by the time you include the available earned income credit and child tax credit, the refund goes up to $8,900. That would pay for a few Christmas presents at the end of the year.

The problem we see all too often is that people believe they will automatically be penalized if they file late. This is true if you have a balance due – but many non-filers have overpaid their taxes. When you let this fear overtake you and you don’t file, you are running the risk of letting the IRS keep money that is rightfully yours. Remember, you have three years from the due date of the return to file a claim for a refund. For 2011, the tax return is due April 17, 2012. That means that you must claim a refund by April 17, 2015. File even one day late and that $8,900 goes away.

The foregoing example was fairly clear-cut because your gross income would have exceeded the amount required for filing. What happens if your gross income is less than what is required for filing?

Let’s assume that you retired with your Social Security and $1 million in mutual funds four years ago. Since you also had some cash built up, you didn’t touch the mutual funds. Two years ago, however, you had to remodel your house to make it wheelchair accessible, so you sold $50,000 in mutual funds to pay the bills. At that time, your investments were underwater and you actually lost money on the sale. Since you didn’t make any money and Social Security wasn’t taxable, you saw no reason to file a tax return.

In truth, you would not have had to pay any taxes if you filed your return, but all the IRS knows is that it received a notice from your stockbroker that you sold $50,000 in mutual funds, so they send you a bill for taxes on the entire amount, plus interest and penalty. Not only does it bill you for the income from the mutual fund sales, but it also calculates that a portion of your Social Security benefits are taxable. To correct the errors with the IRS, you will probably spend more time than if you had just filed your return to begin with.

Tax professionals have seen these and many other instances where one would think the decision to not file a return makes sense. Unfortunately, the tax code and its practical application do not always make sense. Unless you are certain there is no way the IRS can construe that you exceed the minimum filing requirements, it’s always a better idea to file than not to file. Even if you are filing late, it is generally wiser to fulfill your filing duties than to bury you head in the sand.

If you have any doubt about your tax filing situation, give us a call. We’ll be glad to help.


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