There are plenty of reasons your tax return could get audited, and many are beyond your control. For example, if you have some unusually large but legitimate deductions, the IRS may want to take a closer look just to be sure. However, there are some mistakes people make that can trigger audits as well, and many of these are 100% avoidable. Here are three mistakes commonly made by investors that could get your tax return audited by the IRS.
Not reporting taxable retirement account distributions
It's fairly common knowledge that distributions from traditional IRAs and 401(k)s are counted as taxable income, so make sure you report it all. Granted, if your retirement savings produce a large portion of your income, it's tough to forget about it on your tax return. However, there are some situations where a retirement withdrawal could legitimately slip your mind.
For example, the IRS allows a one-time $10,000 early distribution from an IRA to be used toward a first-time home purchase. What many (especially younger) investors fail to realize is that even though you don't have to pay an early withdrawal penalty on the distribution, it is still taxable and must be claimed as income on your return, if you received a deduction when you made the IRA contribution.
All distributions from retirement accounts (even IRA funds that you intend to roll over) are reported to the IRS on Form 1099-R, and if the numbers don't match up to what you claim on your return, an audit could be in your future.
Mathematical and numerical errors
Sure, mathematical errors are not an investor-specific problem, but investors have more calculations to do than the average taxpayer, and more numbers means more potential for mistakes.
Here's the point to keep in mind: Virtually all of the tax information you receive is also sent to the IRS. So the IRS knows how much dividend income your investments generated, how much your capital gains were for the year, and the interest income you received.
Further, I'm not talking about basic math errors, such as calculating your capital gains tax liability incorrectly. The vast majority of people use tax-prep software, which takes care of your calculations. However, the software has no way of detecting when wrong numbers are entered, or when things you need to add by hand are incorrect. For example, if you earned $5,000 in dividend income and accidentally type in $500, the IRS's paperwork and your tax return won't match up and it could trigger an audit.
Violating the wash-sale rule
It's a common practice, and a perfectly legal one, to sell losing investments to offset some of your capital gains or ordinary income -- a process known as "tax-loss harvesting." The IRS allows this, and even if you don't have capital gains to offset, investment losses can reduce your taxable income by as much as $3,000.
A word of caution: When doing so, be careful not to violate the wash-sale rule. Basically, this rule says that if you sell a stock at a loss, and then buy a "substantially identical" stock within 30 days of the sale, you are not allowed to claim the loss in your taxes. Instead, you simply add the loss to the cost of the new purchase.
For example, let's say that you bought 50 shares of a certain stock for $100 a year ago, and the shares are currently trading at $80. If you sell the shares, you can claim the $1,000 loss on your taxes. However, if you buy your 50 shares back for $80 each a week later, you can no longer claim the loss -- the $1,000 loss simply carries over to the new trade.
Since the IRS can see the tax documents sent by your brokerage (see the pattern here?), trying to claim a loss in a wash sale is good way to invite an audit.
There are plenty of other ways to get audited
In addition to these investor-specific tax mistakes, there are many other ways you can bring on a tax audit. For example, if your deductions are unusually high, it could trigger an audit of your entire tax return. The same can be said for deductions with high potential for abuse, such as the home office deduction or business use of a vehicle. And, some tax returns are simply selected at random.
The point is that there is always a chance of an audit, so your goal should be to make it as error-free as possible right from the start.
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