8 Tax Mistakes You Can't Afford to Make

As the April 15 tax-filing deadline approaches, you're running out of time to get your taxes done. But smart tax planning doesn't start in April. To truly get on top of your taxes, you need to always be thinking ahead. As you prepare your 2012 return, don't forget about changes you can do right now to make your 2013 tax situation a lot better.

The best way to make taxes a lot less painful is to avoid making unnecessary mistakes. Below, we'll look at eight things taxpayers commonly do wrong that can cost them thousands of dollars in extra taxes.

Recommendation: Pay less in taxes by using the many special tax-favored accounts that the IRS allows.

  • IRAs, 401(k) plans, and other employer-sponsored retirement accounts.
  • 529 plans and Coverdell Education Savings Accounts, which offer tax-free growth when proceeds are used for approved expenses.
  • Health savings accounts and flexible spending accounts provide tax benefits for your medical spending.

Bottom line: Not using these accounts is like handing over free money to Uncle Sam.



Recommendation: When possible, opt for longer holding periods, since the capital gains rate you pay depends on how long you held the investment.

  • Hold an investment less than a year, and you'll pay your ordinary rate of as much as 39.6% this year.
  • Hold it more than a year, and the maximum is 20%, with many taxpayers paying lower rates of 15% or even 0%.

Bottom line: Long-term investing can be rewarding.



Recommendation: You must have enough tax withheld from your paycheck to cover most of your tax liability when you file your return.

  • If you don't withhold enough, you'll pay penalties and interest on what you should have paid in estimated taxes.

Bottom line: It's too late to fix for the 2012 tax year, but be sure to look up Form 1040-ES to make sure you're in good shape this year.



Recommendation: If you have tax-favored accounts, make sure you use them wisely.

  • High-income bonds, as well as real estate investment trusts Annaly Capital (NYSE: NLY  ) and American Capital Agency (NASDAQ: AGNC  ) produce income that's typically taxed at high ordinary-income rates, and so they often do best in IRAs rather than taxable accounts.
  • By contrast, a low- or no-dividend stock that you buy and hold for decades may actually cost you more in taxes in an IRA than a taxable account.

Bottom line: Position your investments to make the most of available tax savings.



Recommendation: Be smart about harvesting tax losses, timing deductible expenses, or deferring taxable income.

  • Late last year, many taxpayers did their best to pull income into 2012 and leave deductions for 2013 in order to capture lower 2012 tax rates and reduce their 2013 tax liability.

Bottom line: With taxes, timing is key.



Recommendation: Be sure to consider special tax rules for certain investments

  • For instance, precious-metals investors need to be aware that because of their structure, SPDR Gold (NYSEMKT: GLD  ) and iShares Silver (NYSEMKT: SLV  ) have their gains taxed as collectibles, which carries a higher rate on capital gains even if you hold the shares for more than a year.
  • Selling too soon after receiving a dividend can take away the lower tax rate on your payout.

Bottom line: Be careful before you sell.



Recommendation: Be sure you have the records to back up the figures on your return so that you can defend your filing during a possible audit.

  • Many tax benefits require documentation to prove that you're entitled to them.
  • For instance, when you give to charity, you should get an acknowledgment letter showing that you made a donation and didn't get anything of value for it.
  • But with some donations, such as gifts of vehicles or expensive property, further documentation or even a formal appraisal may be necessary.

Bottom line: Forewarned is forearmed.



Recommendation: Even if you can't pay, you should still file in order to avoid huge penalties.

  • The penalty for not filing is 10 times as much as the penalty for not paying on a filed return.

Bottom line: Even if you are in financial straits, save yourself some big money and prepare your return anyway.

Making the right financial decisions today makes a world of difference in your golden years, but with most people chronically under-saving for retirement it's clear not enough is being done. Don't make the same mistakes as the masses. Learn about The Shocking Can't-Miss Truth about Your Retirement. It won't cost you a thing, but don't wait, because your free report won't be available forever.

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Read/Post Comments (15) | Recommend This Article (87)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 19, 2013, at 4:02 PM, TheRealRacc wrote:

    Can you help clarify how a dividend stock in an IRA can result in higher taxes?

  • Report this Comment On March 19, 2013, at 4:16 PM, TMFGalagan wrote:

    @TheRealRacc - When you pull the dividend out of the IRA at retirement, it, along with the rest of your withdrawal, gets taxed at ordinary income rates. In other words, you lose the ability to use the beneficial lower tax rates on dividends when you have them in an IRA. The same is true for capital gains.

    best,

    dan (TMF Galagan)

  • Report this Comment On March 20, 2013, at 11:44 AM, StopPrintinMoney wrote:

    529 contributions are not deductible from the federal income taxes, only from the state. Just saying....

  • Report this Comment On March 20, 2013, at 7:33 PM, MikeyG21 wrote:

    I think you should advise people on two ways to treat overseas dividend income. Big difference in cost

  • Report this Comment On March 20, 2013, at 10:09 PM, jasjfarrell wrote:

    How about converting portions of a regular IRA into a roth little by little?

  • Report this Comment On March 20, 2013, at 11:25 PM, Jon2012 wrote:

    I am 65. I live in California. What will the State and Federal Tax Rates be if I take a distribution from my IRA?

  • Report this Comment On March 21, 2013, at 12:44 AM, agwisreal wrote:

    If you expect taxes to be higher in the future, and you can afford to convert a portion of your regular IRA to a Roth and pay taxes on that conversion now, it could be a good play. But be aware that unlike with distributions, the IRS doesn't automatically get its cut. You have to pay it out of your other income.

  • Report this Comment On March 22, 2013, at 7:58 PM, rudolphm wrote:

    I joined TMF for information on investing. Can we please limit the comments to that?

  • Report this Comment On March 22, 2013, at 8:12 PM, Gailen wrote:

    I think the comment about no dividend/all capital gains stocks generating higher taxes in an IRA than in a non-tax sheltered account misses the point and is comparing apples and oranges. The focus on how much taxes are paid is a mistake. One should focus on the amount of after-tax funds available rather that the taxes paid.

    Consider the amount one can invest. Suppose I can put $10,000 in and IRA and buy $10,000 worth of stock. If I am in, say, the 35% bracket, and I don't contribute to the IRA I can only invest $6,500 in the same stock. I defy anyone to show how I am better off paying capital gains on the "outside" investment rather paying ordinary taxes on the withdrawal from the larger "inside" investment at the end when I retire.

    I suspect the author assumed the same dollar investment for both inside and outside money which ignores the tax shelter on the original funds.

  • Report this Comment On March 23, 2013, at 8:06 AM, WineHouse wrote:

    Two comments to "agwisrael" --

    1, you wrote something about the IRS "automatically" getting its "cut" when you take your traditional IRA distributions. That's NOT necessarily the case. You have to instruct your IRA trustee (e.g., your bank or brokerage) as to whether or not to withhold taxes from the distribution, and if so, how much. The default is to withhold 20% of the distribution, which may be too much or too little, depending on your other income, but you can instruct them to withhold anything from zero to 100%.

    2 - you wrote about having to pay "out of other income." No. Why limit the source of the tax payment to "income" ?? You just pay it out of whatever money you have, but it doesn't have to be income money. It can be cash accumulated in an account. There's no rule that says you have to have "income" to cover the tax payment.

  • Report this Comment On March 23, 2013, at 8:21 AM, WineHouse wrote:

    a reply to "Gallen" -- a one-time tax deduction on your contribution is just that, a one-time deduction. Depending on how that contribution grows inside the traditional IRA (i.e., as interest on a bond vs. dividends a/o long-term capital gains from "qualified" stocks), and also depending on how you move the investments around during the time the assets are in the t-IRA, you might or might not be better off having had those investments outside, rather than inside, the t-IRA. The reason is because when you withdraw assets from the t-IRA, regardless of the history of the growth, you must pay the "ordinary" income tax rate based on your total income. Imagine the following two extreme scenarios: 1,imagine you make a one-time-only t-IRA contribution, and invest 100% of the t-IRA assets in corporate and treasury bonds, and continually re-invest the interest and the cash from maturing bonds in more such bonds, over a 20-year period. At the same time, you invest the same initial dollar amount in a "regular" (non-sheltered) account, all of it in a stock that pays an ever-increasing dividend that you reinvest in the same stock, and also the stock grows in stock price over the same 20 years; then you sell the stock (use something like Proctor & Gamble as a model). Calculate the tax burdens for the two portfolios. Now, scenario 2: just the opposite -- you put the stock in your t-IRA and the bonds in your regular account. NOW calculate the tax burdens for the two portfolios. If you've done your calculations properly, you will see the very striking difference between those two scenarios and you will understand how relatively unimportant that initial "tax deduction" turns out to be, and how relatively very important the different tax rates are in terms of how the kind of account (t-IRA vs. non-sheltered) influences your total tax burdens.

    Go ahead. Do the math.

  • Report this Comment On March 23, 2013, at 10:06 AM, Gailen wrote:

    Reply to Winehouse:

    You are missing the point. In my example, you either 1) put $10,000 in an IRA or 2) take the income, pay tax of $3,500, and invest $6,500. To keep the comparison fair, as you did initially, invest the two amounts exactly the same way. My claim is that your $10,000 in the IRA will produce greater after-tax income than the $6,500 invested in the identical fashion.

    What you are missing is that the $3,500 saved in taxes is more than a one-time deduction, you get to invest that $3,500 on top of the $6,500 you would have if you had taken the income after paying tax. Consider an investment that doubles in value by the time I retire. How much would I get to keep each way?

    IRA: $10,000(2)(1-0.35) = $13,000

    non-IRA: $6,500(2) - 0.15($6,500) = $12,025

    You do the math, but keep the investment the same either way as you did in your initial post.

  • Report this Comment On March 23, 2013, at 12:36 PM, jrj90620 wrote:

    Every time I read one of these articles about cap gains taxes,it states that long term cap gains tax is 20% or less.That's true in only a few states,with no income tax.Not in Calfornia,where long term cap gains are taxed at 10% or more.That would make your total long term cap gains tax 50% more than this article implies.

  • Report this Comment On March 25, 2013, at 12:51 PM, NWHuskydog wrote:

    RE: Estimated taxes, my tax guy told me that as long as I withhold (or have withheld) the amount I owed last year in taxes, there is no penalty for under-withholding. Is this incorrect?

  • Report this Comment On March 25, 2013, at 4:44 PM, culcha wrote:

    Reply to NWHuskydog

    correct.

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