With tax season right around the corner, it is never too early to start thinking about your 2016 tax return and avoid costly filing errors that many taxpayers make. Even if you file through electronic software or a tax professional, the return you get out is only as good as the information you put in.
The three errors below are all too common and can easily be avoided.
1. Not filing a tax return
This one seems fairly simple. Taxpayers are encouraged to file a tax return every year, even if they do not believe they owe any taxes. Many don't. Every year, as a result, taxpayers lose out on refunds that they may not even know they have coming. After three years, those unclaimed refunds are surrendered to the U.S. Treasury.
In 2016, the IRS reported that it held nearly $1 billion in unclaimed tax refunds for tax year 2012, belonging to over 1 million taxpayers. Any of that money that wasn't claimed by the tax filing deadline back in April went into the Treasury's coffers. The median refund owed was $718 per taxpayer.
Some taxpayers stand to lose much more than the refunds they may be due. Many low-income or moderate-income taxpayers may also be forfeiting the Earned Income Tax Credit, a refundable credit that for 2012 could have amounted to as much as $5,891.
Taxpayers who don't owe any taxes or have a refund coming may be depriving themselves of a substantial windfall by not filing a return.
2. Forgetting to change your filing status
Over the course of the year many taxpayers experience changes in their family dynamic or composition. Couples get married or divorced. Children are born. Students go off to school. Parents or adult children move in. Family members pass away.
One of the most common tax filing errors is failing to reflect the changes in the family dynamic in the taxpayer's filing status. There are five choices for filing status: single, married filing jointly, married filing separately, head of household, and qualifying widow(er) with dependent child. It's as simple as checking the correct box on the form 1040, right? The first three are easy enough, but regulations involving the others can be complex. Examples include supporting an adult family member or choosing between head of household and qualifying widow(er) with dependent children. These may require a visit to your local tax professional. If you have recently experienced any changes in the family dynamic, be sure to update your information, check the correct box, and don't be afraid to call in a professional for the more complex issues. The increase or decrease in taxes related to filing status can be substantial, so it's worth the extra time and effort to ensure that your status is correct.
3. Not updating the cost basis of investments
Many investors enjoy the ease of automatic dividend reinvestment plans, or DRIPs. With a DRIP, dividends are reinvested to buy additional shares of stock or mutual funds; the shareholder never actually receives a dividend check. This results in a virtuous cycle: Buying more shares results in higher dividends, which can in turn buy even more shares. This simple set-it-and-forget-it strategy, combined with dollar-cost averaging and the power of compounding, can result in significant gains over time. Whether you are invested in individual stocks or mutual funds, DRIPs are a popular choice for many taxpayers.
When tax time comes, however, the hands-off approach can work against you. Many investors forget that those additional purchases of stock or mutual funds increase your cost basis. When you calculate your gains from a sale, failing to calculate your increased cost basis can lead you to pay more capital gains taxes than necessary.
Here's an example: You buy 100 shares of Company X for $100 each. Your cost basis is $10,000 (100 x $100 = $10,000). The shares pay a $1 dividend each quarter, which is reinvested to buy additional shares. Assume the new shares cost $100 per share as well. Your dividend reinvestment for the year would be $400 ($1 dividend x 100 shares x 4 quarters = $400). At the end of this year, you calculate your cost basis by adding your original investment, plus the cost of the additional shares, which comes to $10,400 ($10,000 + $400).
Now that you have calculated your cost basis, how does this affect your taxes? Let's say you sold your stock for $11,000. You would subtract your cost basis ($10,400) from your proceeds ($11,000 - $10,400), and you would pay capital gains taxes on $600. If you didn't adjust your cost basis and assumed it was still $10,000, then you'd end up paying capital gains on $1,000 ($11,000 - $10,000) instead of your actual gains of $600. Assuming you paid a capital gains tax rate of 15% (like most investors), then that would cost you an extra $60 -- that's not a huge amount, but over your entire investing portfolio, these little errors can really add up.
Cost basis is one of the most frequently miscalculated figures on Americans' tax returns. Be sure to keep accurate records of your investments and dividend reinvestment so that you are not overpaying. Investopedia provides a dividend reinvestment calculator to assist with those calculations here.
Each of these errors is fairly common and can easily be avoided by careful record-keeping and timely tax filing. If you find yourself facing any of these situations and are still unsure, pay a visit to your local tax professional for help.
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