The Most Common Misunderstandings About Tax Returns and Refunds

The U.S. tax code is complex. The federal internal revenue code is millions of words in length, and there are some important concepts that many Americans don't understand. While I can't debunk every tax myth, here are three of the biggest misunderstandings you should know the truth about as tax season gets underway.

Misunderstanding 1: A tax extension gives you extra time to pay

If you aren't ready to file your tax return by the April tax deadline this year, it's fairly easy to file for an extension. If you file an extension, you'll get an extra six months to file, making your tax return due on Oct. 15, 2024. (Note: You may need to file a separate extension with your state as well.)

However, one of the biggest (and most costly) misconceptions is that a tax extension gives you more time to file and more time to pay. This is not the case; your federal income tax is still due in April. If you anticipate that you'll owe money, you're expected to pay it along with your extension request.

Having said that, if you can't pay, still file for an extension. The penalties for failing to file a tax return are far more severe than the penalties for not paying on time. But the point is that you will face interest and penalties on any money you owe after April 15, even if you file an extension.

Misunderstanding 2: Only rich people get audited

Higher-income households certainly have a higher probability of being audited than the average taxpayer. But you might be surprised to learn that one of the most common groups of taxpayers who get audited are those on the lower end of the income spectrum, and that's especially true if you claim the Earned Income Tax Credit (EITC). In fact, returns with less than $25,000 in gross income and the EITC had a higher audit rate than business owners who earned $200,000 to $1 million.

The reason for this is that the EITC credit is valuable and has high potential for fraud, so it naturally receives more scrutiny.

Misunderstanding 3: An audit is always a terrible experience

When many people hear the term "tax audit," they picture a bunch of IRS agents in suits showing up at their homes or being asked to come into an IRS office.

While this is certainly possible, especially if there's a big issue with your return (such as failing to report a large amount of income), the most common type of audit is known as a correspondence audit. This simply means that the IRS sends a letter in the mail, typically to ask for more documentation on a specific item or to make an adjustment to a taxpayer's return based on information it has received. And in these cases, you can simply send in documents to support the information in your tax return or agree with the IRS's proposed changes.

In fact, 85% of all tax audits in 2022 were correspondence audits. And with only 0.38% of all tax returns receiving any scrutiny, this means that the chance of an audit by an actual IRS agent is about 0.06%, or six returns of every 10,000.

Not an exhaustive list

To be sure, the U.S. tax code is extremely complex, so there is quite a bit that the average American doesn't fully understand about the tax code. However, these are three of the most common misconceptions that I see people make that could have major personal finance implications.