The 10 Worst Tax Moves You Can Make
Before long, it will be 2014, and you'll have to think about filing your tax return. Don't freak out, you have some time. But it's important to make the right decisions to avoid paying more tax than you have to, and to plan correctly for the following tax year. Here are 10 bad tax moves that everyone should avoid. (See also: 5 Year-End Tax Planning Moves)
1. Paying Your Taxes Late (Or Not at All)
The IRS reports that between 20 and 25 percent of taxpayers wait until the last two weeks to file their taxes. It may be common to cut it close, but you don't want to blow right through it. The Internal Revenue Service will nail you with a 5% failure-to-file penalty for any unpaid taxes each month until you file. You may be able to avoid some penalties by filing an extension, but that extra time is only for filing a return; it doesn't mean you get more time to pay taxes due. Your best bet is to get your paperwork together and file before the deadline. (See also: Tax Document Checklist)
2. Lying on Your Return
It may be tempting to avoid telling the IRS about some income, exaggerating things to claim deductions, or otherwise fudging things in order to avoid paying taxes. And it's true that the IRS only audits a very small percentage of returns. But if you do get nailed, you'll be forced to pay a penalty of 75% of the understatement, according to the IRS. Egregious cases will be referred to the criminal investigations division.
3. Making Mistakes on Your Return
No one likes doing their taxes, but if you rush through them and make an error, it could cost you. If you accidentally understate the amount you owe, you may end up facing a 20% penalty. (And that's only if you can prove to the IRS that it was a mistake and not fraud.) Clerical errors like misspelling your name or entering the wrong social security number will delay your return.
Hiring a professional to do your taxes will reduce the likelihood of mistakes. If you prefer to do your own taxes, use a program like TurboTax, which automatically checks for errors. (See also: 6 Places to Get Free Tax Advice)
4. Withholding Too Much (or Too Little)
If you are employed, taxes will be taken out of your paycheck, but it's very important to make sure you're not taking out too much or too little. If your withholding is off base, you could be stuck owing a large sum or getting too much in a refund. (Yes, a big refund can be a bad thing. It means the government's been holding on to your money for no reason.)
Your withholding is determined by the information you fill out on your W-4 form, which you probably filled out when you got hired. This includes information on your marital status and the number of dependents in your household. (Be sure to adjust your withholding if you have a child, get married, or if you are taking care of an elderly relative.) The IRS has a calculator to help you figure this out, but it's up to you to change the W-4 form itself.
5. Investing Without Thinking About Taxes
Taxes on dividends and capital gains will take away a big chunk of your return on investments. Rates vary, but high-income earners could give back as much as 23.8% of their capital gains to the IRS. For most people saving for retirement, it's wise to consider a plan that offers a way to avoid or reduce these taxes, or to otherwise reduce your liability. (See also: How to Choose a Retirement Account)
If your employer offers a 401(k), any money you contribute is deducted from your taxable income. A Roth IRA works in reverse — your contributions are taxed immediately, but you pay no taxes when you cash out down the road. Many financial advisors suggest having both of these accounts, because it's not easy to predict what tax bracket you'll be in when you retire.
Also take a look at 529 plans and Coverdell ESA accounts for similar tax advantages on college and other educational expenses.
6. Not Keeping Up With Tax News
It's understandable that the average person won't know all of the ins and outs of the tax code. But keeping up with changes in tax policy will help you prepare for negative changes and also help you take advantage of new programs. In many instances you may qualify for new tax credits or deductions that you didn't even know existed.
In 2013, marginal tax rates will be unchanged for most people, but the payroll tax holiday ended, meaning a 6.2% withholding rate for people making up to $113,000. (Have you noticed less money in your take-home pay?)
There were also some other changes affecting higher earners in 2013, and the new Affordable Care Act could have major implications for many Americans and their taxes. Don't get caught by surprise.
7. Renting When You Can Buy
We'll concede that the decision to purchase a home is a personal one, and not one you should rush into. But from a taxation standpoint, there is considerable savings to be had. Homeowners get to claim a mortgage interest deduction on their taxes, and often will qualify for other tax credits and programs.
Your exact savings will depend on how much you earn, as well as your interest rate and the size of your loan. But let's assume you're a married couple with an income of $100,000 and home priced at about $210,000 (the current national median.) According to Bankrate.com, you will save more than $3,000 on your taxes in the first year with a 30-year loan at the current average fixed rate.
Homeowners do usually have to pay local property taxes, but those are deductible from your federal tax bill.
If you're weighing the pros and cons of buying a home, it's helpful to take these savings into account.
8. Treating Your Refund Like It's a Bonus
Every year at tax time, we hear people chatting about how they'll spend their tax refund, as if it's a spring bonus check from Uncle Sam. This is terribly flawed thinking. If you get a refund, it means that the government has held on to your money for most of the year. (See the above entry on tax withholding.) Moreover, tax refunds are not easily predictable, so it's dangerous to assume you'll be getting a certain amount. The smartest move is to budget as if no refund is coming. It may even help to set aside some funds in case you owe the taxman.
If you do get a refund, resist the urge to get a refund anticipation loan, which can take out hundreds of dollars in fees.
9. Not Giving to Charity
There are obvious benefits to giving away a portion of your money to causes and people you care about. It helps society and makes you feel good, but it can also help you lower your tax bill.
When you give to a charity, that money can be deducted from your taxable income. And it's not just money that's deductible. You can deduct donated items like food or clothing, and you can even deduct any mileage on your car that you incur while performing charity work.
When my family recently renovated our house, we found a charity that took our old windows and doors and repurposed them; we got a sizable tax deduction in the process. If you have an old car you want to unload, consider donating that to charity as well.
To take advantage of these deductions, you'll need to keep good records what you give, and itemize those deductions on your tax return.
10. Keeping Poor Records
Records are crucial to everything from proving wages, properly valuing investments, and identifying business expenses.
When you get wage statements from your employer, keep them handy. The same goes for any statements relating to your brokerage accounts and retirement plans. Numbers like your salary and retirement contributions aren't things you want to guess on, as they have a direct impact on how much tax you pay.
It's also important to save previous years' returns. The IRS advises you to save at least three years of returns, and some people advise to never throw out a return, ever.
Also keep records of any investments or major things you buy. It's common for people to buy things like shares of stock or equipment and then claim capital losses or depreciation on their taxes. But to do this, you need to prove when you made the purchases.
Any tax mistakes I've missed? Please share them in comments!