With tax season rapidly approaching, many of us are starting to gather our paperwork and work on hammering out our returns. But in reality, tax planning is something you should focus on year-round, and not just during the first few months of the year. Here are three tax mistakes you can take steps to avoid, no matter the season.
1. Failing to report income
Any time you earn money, whether it's from selling an investment or doing a freelance project on the side, you're required to report and pay taxes on your earnings. And if you try keeping those payments to yourself, you could get in trouble. Any time you receive a 1099 form listing income you've been paid, the IRS gets its own copy. If you fail to report that income and pay taxes on it, you could quickly find yourself on that dreaded audit list.
Of course, 1099s aren't always correct, but if you get a form listing the wrong amount, don't just ignore it or report your version of that number on your tax return. Rather, contact the issuer, resolve the discrepancy, and make sure a new form goes out. Even if you're in the right, the IRS isn't going to just take your word for it, and if the amount you report doesn't match what the IRS is seeing, you're the one who might pay for that inconsistency.
2. Playing it fast and loose with deductions
There are a number of legitimate tax deductions that can work wonders for reducing your tax liability. Homeowners, for example, can claim a mortgage interest deduction and write off their property tax payments. But while there's nothing wrong with taking legitimate deductions, some tax filers run into trouble by getting too creative or guessing at deductions they don't have documentation to support.
Take medical expenses, for example. You're allowed to deduct out-of-pocket medical costs that exceed 10% of your adjusted gross income, but if you don't retain your receipts, you're more likely to guess at your total spending than put down an accurate figure. And that's something the IRS might notice, especially if you list a remarkably round figure. After all, what's the likelihood that your costs for the year magically worked out to $5,000 exactly?
Unsubstantiated mileage deductions could also get you into trouble. You're allowed to deduct mileage if you use your vehicle for business, but you need to keep an accurate log of where you travel to, the purpose behind each trip, and its distance. Claiming 5,000 business miles for the year, for instance, is almost too clean a number to be true, and it's likely to get you into trouble if you don't have records to support it.
Finally, be careful with charitable contributions. Though you can take a deduction for cash or goods that you donate to charity, you need to retain a receipt for each donation you claim. And if you claim too high a deduction, you might land yourself on the IRS audit list. For example, in 2014, the average American earning $60,000 took a $2,970 deduction for donations. If you earn a similar salary but claim a $9,000 deduction, it could raise a red flag, as most people don't give 15% of their income away to charity.
3. Not contributing to a retirement account
While failing to contribute to a retirement account won't increase your chance of an audit, it will mean losing out on a major opportunity to save money on taxes, both now and over time. When you contribute to a retirement account like a 401(k) or IRA, the money you invest gets to grow on a tax-deferred basis until the time comes to take withdrawals.
Regular bank or brokerage accounts don't offer this same benefit. When you leave your money in a savings account to grow, the (minimal) interest income you earn will be subject to ordinary income taxes year after year. Similarly, if you invest with a traditional brokerage account and sell investments at a profit, you'll be subject to taxes each tax year you realize a capital gain. On the other hand, if you invest with a 401(k) or IRA, realized gains won't immediately subject you to taxes.
Furthermore, if you open a traditional IRA or participate in an employer-sponsored 401(k), you can contribute money on a pre-tax basis, which will lower your immediate tax bill. A $5,000 contribution, for example, will shave $1,250 off your tax bill if your effective tax rate is 25%. While Roth 401(k)s and IRAs don't offer an upfront tax break, withdrawals are taken tax-free in retirement, which can be an even greater benefit.
We all want to not only save money on taxes, but ensure that the filing process goes as smoothly as possible. Dodging these mistakes could put more money back in your pocket while helping you avoid a potentially stressful tax audit. And that's a win-win.