Paying taxes is part of life, but it can be a very complicated process, so there's plenty of room for error. It's something you'll have to do every year, and you don't want to make the same expensive mistakes over and over. Get familiar with the 10 biggest mistakes tax filers make and you could save yourself thousands over the years, starting this tax season.
The Internal Revenue Service, the federal agency responsible for overseeing the U.S. taxation system, collected and processed more than 245 million tax returns and collected more than $3.4 trillion in fiscal year 2017. Surprisingly, nearly half of Americans (48% to be exact) think their contribution was fair and the taxes they paid were just right, according to the IRS.
It's important to understand how to comply with tax rules to avoid audits, civil lawsuits, and even criminal prosecution. But you don't want to pay more than necessary or miss out on valuable credits and deductions you're entitled to. Let's take a look at some of the easiest mistakes to make, find out their potential consequences, and learn how to avoid making them.
To avoid costly errors, here are some of the most common tax mistakes that can cost you big bucks:
- Choosing the wrong filing status
- Failing to claim deductions and credits you're owed
- Claiming deductions and credits you're not entitled to
- Making the wrong choice about itemizing
- Throwing away tax paperwork
- Missing out on tax-advantaged investments
- Not reporting all your income
- Getting a tax refund
- Not getting help filing your taxes
- Not filing or not paying taxes on time
1. Choosing the wrong filing status
Your filing status determines your tax rate and your eligibility for certain deductions. If you choose the wrong filing status on your tax return, you could underpay or overpay your taxes -- both of which are mistakes with substantial cost implications.
When you file your taxes, choose your filing status from these options:
- Married filing jointly
- Married filing separately
- Qualifying widow or widower
- Head of household
If you file as married filing separately instead of married filing jointly, you could cost yourself thousands in tax breaks. When you file separately, you can't claim the earned income tax credit (EITC), which has an average value of more than $2,400 and a maximum value of $6,431 (for people with three qualifying children). There's a long list of other credits you can't claim under this filing status, including the American Opportunity Tax Credit and the Lifetime Learning Credit. You're also excluded from taking certain deductions, such as the student loan interest deduction.
Or, if you file as single when you'd have been eligible to file as head of household, you could end up in a higher tax bracket and have a lower income threshold at which eligibility for certain deductions and credits phases out.
An illustration: Say you have $50,000 in taxable income and file as single. You'd be in the 22% tax bracket. You'd owe $4,453.50 plus 22% of the amount over $38,700, or $6,939.50 in total taxes. But if you'd been eligible to file as head of household, you'd be in the 12% tax bracket. You'd owe $1,360 plus 12% of the amount over $13,600, or $5,728 in taxes. That's $1,211.50 less.
To avoid choosing the wrong filing status, learn the eligibility requirements for each.
- You can file as married if, on December 31, you were legally living together as spouses, you were living together in a common law marriage recognized by your state, you were legally married and living separately but weren't legally separated, or your spouse died during the tax year. Married filers must choose between married filing separately and married filing jointly. Filers who choose married filing separately become limited in the deductions and credits they can claim.
- You can file as single if you're divorced or widowed or have never been married.
- You can file as head of household if you're unmarried on the last day of the year; you paid more than half the cost of maintaining a home for the year; and a "qualifying person" lives with you or you're supporting a qualifying person. A qualifying person could be a child, an aging parent you're caring for, or other people you support. This IRS guide can help you determine if you have a qualifying person.
- You can file as a widow or widower with a dependent child if you were eligible to file a joint return with your spouse in the year of his or her death, you haven't remarried, your spouse died in the prior two years, and you maintain a home for at least one dependent child. This IRS guide explains how you determine if your child is a dependent or not.
The IRS also has an online tool to help you to determine your filing status. Research each option carefully and among the filing statuses that you're legally eligible to use, pick the one that results in the lowest tax rate and eligibility for the most credits and deductions. And speaking of those...
2. Failing to claim deductions and credits you're owed
Deductions and credits can both reduce your overall tax bill, but they do so in different ways.
- Deductions reduce your taxable income. This means the amount you save is based on your tax rate. If you'd have had a taxable income of $50,000 and you claim a $1,000 deduction, your taxable income goes down to $49,000. If you're in the 12% tax bracket, you'd save $1,000 x 12%, or 120. If you're in the 22% tax bracket, you'd save $1,000 x 22%, or $220.
- Credits are a dollar-for-dollar reduction in taxes. If you would've owed $2,000 in taxes and you get a $1,000 credit, your $1,000 credit means you now owe just $1,000. The $1,000 credit saved you a full $1,000, whereas a $1,000 deduction would've saved just a few hundred dollars.
There's a very long list of credits and deductions listed in the tax code for taxpayers to consider claiming. You're probably eligible for some deductions or credits if you are raising kids, are paying for college for yourself or for a dependent, have medical expenses that exceed 7.5% of your income, pay state or local property taxes, make energy-efficient improvements to your home, pay taxes as a lower-income wage earner, pay mortgage or student loan interest, or contribute to a savings account like a retirement or health savings account (HSA).
The specific tax deductions and tax credits you can claim vary depending upon your filing status, the income you earn, your family structure, your expenditures throughout the year, and whether you itemize on your taxes or not (we'll go over itemizing in Mistake #4). Some deductions, such as the deduction for student loan interest, have an income limit. If you earn more than a certain amount in that tax year, you aren't eligible to claim these deductions.
Sadly, far too many deductions go unclaimed. For example, the IRS estimates as many as 20% of people who could've claimed the EITC don't claim it. This credit alone could be worth as much as $6,341, and it's refundable, meaning if the credit makes your tax bill positive, the government gives you the difference in cash.
How can you make sure you're claiming all the deductions and credits you're owed? One of the best ways is to use a high-quality online tax filing program. Most tax filing software programs ask you simple questions about your life, and the software uses your answers to identify deductions and credits you may be eligible for.
3. Claiming deductions and credits you're not entitled to
While you want to claim every single deduction and credit you're owed, you don't want to claim any tax breaks that you aren't actually eligible for. Trying to pull a fast one on the IRS could get you audited, and if you get caught, you could owe back taxes, interest, and penalties.
Some deductions are more likely than others to catch the eye of the IRS and trigger an audit, including deductions for business travel and entertainment, deductions for charitable contributions that seem unusually high, and deductions for a vehicle for business use.
If you're legitimately entitled to a deduction, don't be afraid to take it. But don't break the rules by trying to claim tax deductions and credits you aren't eligible for.
4. Making the wrong choice about itemizing
When you file your taxes, you have a choice between claiming a standard deduction and itemizing your specific deductions. If you itemize, you cannot claim the standard deduction. You must choose one or the other.
There are some deductions you can claim even without itemizing, such as deductions for contributing to an individual retirement account (IRA) or the student loan interest deduction. But many other deductions can be claimed only if you itemize, giving up your right to claim the standard deduction. If you want to deduct mortgage interest, local taxes, investment interest expenses, medical costs, or charitable deductions, you must itemize on your tax return.
To decide if it makes sense to itemize or not, figure out what the standard deduction is for your filing status. Next, determine what itemized deductions you're eligible for. If the total value of your itemized deductions exceeds your standard deduction, you should itemize. If the total value of your standard deduction is greater, itemizing will lose you money.
The Tax Cuts and Jobs Act significantly increased the standard deduction beginning in tax year 2018. Here's what your standard deduction will be for both tax year 2018 and tax year 2019:
Tax Filing Status
2018 Standard Deduction
2019 Standard Deduction
Married filing jointly
Head of household
Other filing statuses
So if you are a married couple with itemized deductions of just $11,000, you wouldn't itemize. If you did, your deduction would be $13,000 smaller, so your 2018 taxable income would be $13,000 higher. If you were in the 22% tax bracket, you'd pay an extra $2,860.
But if you're married and you have itemized deductions of $40,000 and you claimed the $24,000 standard deduction in 2018, you'd lose out on $16,000 in deductions and your taxable income would be $16,000 higher. Assuming again that you're in the 22% tax bracket, you'd pay an extra $3,520.
5. Throwing away tax paperwork
Your employer sends you tax paperwork each year, including a report of the wages you paid and taxes taken out of your check. If you earn nonwage income, such as from a business, a rental property, or alimony, you'll receive a tax document called a 1099 form. You'll receive forms showing your investment income or losses, contributions to retirement accounts, and mortgage or student loan interest.
In other words, your mailbox is going to be full of tax forms in January and February. When you get this paperwork, don't throw it away. You'll need all of it when you file your taxes in order to properly report your income and to claim your deductions and credits.
Copies of the tax forms you receive are sent to the IRS by whoever issues your wages or income, so if you don't report what's on these forms, you can expect the IRS to ask questions. If all your income from your 1099 forms adds up to $5,000, but you misplaced one of the forms with $1,000 in income and declared just $4,000 instead, the IRS will inquire about that extra $1,000.
If you claim deductions and credits, you may also need additional paperwork to substantiate those tax breaks. For example, if you itemize and claim deductions for charitable contributions or for medical costs that exceeded 7.5% of your income, make sure you have your medical bills and receipts from charitable donations. If you're audited and don't have this documentation, the IRS could claim you weren't actually eligible for the deduction and levy penalties, back taxes, and interest on the amount of taxes that went unpaid because of the "improper" deduction.
6. Missing out on tax-advantaged investments
If you aren't investing in accounts that provide you with a tax break, you're making your taxes way higher than they have to be -- and you're skipping important help from the government to save for your future.
A number of accounts provide tax breaks, including:
- A 401(k) if your employer offers one, a 403(b) if you work for a public school or tax-exempt organization, or a Solo 401(k) if you're self-employed.
- A traditional IRA (if you want to claim a tax deduction for contributions up front) or a Roth IRA (if you want to invest with after-tax dollars and make tax-free withdrawals as a senior).
- IRAs for small business owners or the self-employed, including a SEP IRA or a Simple IRA.
- Health savings accounts (HSAs), if you have a qualifying high-deductible health plan (HDHP).
- 529 accounts, if you want to make tax-deductible contributions to an education savings fund.
For all but Roth IRAs, these accounts allow you to take a tax deduction for the investments you make. And with some of these accounts, including HSAs and 529 accounts, you can also enjoy tax-free growth as long as you withdraw money to pay for qualifying healthcare or educational expenses.
When you contribute to an investment account with tax-deductible dollars, your taxable income is reduced by the amount you invest. And this could be thousands of dollars, up to the maximum for that account.
In 2018, the maximum contribution you can make to a 401(k) is $18,500, or $24,500 if you're 50 or older. If you contribute the full $18,500 and you're in the 22% tax bracket, you'd save $4,070 on your taxes. And you don't have to itemize to claim this deduction.
Even if you can't afford to max out your contributions, it's a big mistake not to contribute anything to an account to save for healthcare costs, your future, or your child's future. The government is giving you a rare tax break and helping you save, and you are certain to eventually need this money.
7. Not reporting all your income
If you don't report all the income you earn, chances are good the IRS will find out. Because the IRS receives forms like W-2s and 1099s for all the income you earn, it's easy to see if you didn't report everything you owe.
If you don't report all your taxable income, you could face criminal prosecution or a civil lawsuit to collect taxes on undeclared income. You could end up owing interest and penalties if you underreported what you earned, so just don't do it.
If you own a business and earn your income in cash, it might be harder for the IRS to find out you aren't declaring all your income -- since there are no form copies documenting it. But the IRS may still discover you had income you didn't report using a number of tools they have for this purpose.
For example, the IRS will look at your business financial ratios, such as your gross income or profit ratio, and compare them to those of similar companies. If it appears you're reporting far less profit, or far greater expenses, than competitors, this raises a red flag.
The IRS can demand lots of information from you through an audit to try to find any unreported income. Auditors analyze bank statements and assess whether your reported income is enough to sustain your lifestyle. If your annual expenses significantly exceed the income you've declared, the IRS is going to have strong reason to believe you aren't being truthful in reporting all the money you earned.
8. Getting a tax refund
The IRS handed out close to $437 billion in tax refunds in fiscal year 2017. This may seem like a good thing, but it's actually not. If you got a refund, it means you gave the IRS an interest-free loan, and by doing this, you really cost yourself money and opportunities.
If you loaned the IRS money, you missed out on the chance to use those funds during the year. Giving the IRS an interest-free loan could cost you money in a number of ways.
Let's look at some examples of the opportunity costs: You could pay more interest on debt. Let's say you get a $2,500 tax refund, which means you overpaid your taxes by about $208 monthly. If you had a credit card at 17% interest you owed $5,000 on and were making minimum payments of $100 monthly, you'd owe $4621.40 at the end of 12 months. If you used your $2,500 refund to pay down that debt, you'd be left with a $2,121.40 balance.
But had you not overpaid taxes and gotten a refund, you could've increased your payments on the credit card to $308 per month. At the end of 12 months, you'd have whittled your balance down to just $1,921.44 --$200 less. So if you got a refund because you overpaid the IRS, you cost yourself $200 -- even if you used your eventual refund to pay down the same debt.
You also lose the chance to invest the money you overpay the IRS. If you invested $208 monthly instead of loaning it to the IRS, and earned an 8% return, you'd have $2,589 at the end of a year. You'd be $89 richer than if you overpaid taxes and got a $2,500 refund.
You could also invest that $208 monthly in a savings account to build an emergency fund, which would help you avoid debt when you incur unexpected costs. If you've loaned the IRS money by paying too much in taxes during the year, you could end up having to pull out your card to borrow and pay interest to cover any emergency.
You can avoid this tax mistake by using the IRS withholding calculator to make sure your employer is withholding an appropriate amount from your paycheck. Let your employer know to update your withholding if you're having too much money taken out. And when you start a new job, complete your Form W-4 accurately so the right amount of money is withheld.
9. Not getting help filing your taxes
Taxes can be complicated. But you don't have to do them on your own.
You can use an online software program designed to make filing easy. If you make below $66,000, there are free programs you can use to file your federal tax returns, and sometimes your state tax returns. There are also accountant assistance programs for low-income earners and seniors, such as the Volunteer Income Tax Assistance (VITA) program and the Tax Counseling for the Elderly (TCE) program.
If you go the online avenue, look for a program with a strong reputation for simplicity, and try to use the same one every year, because they usually store your prior year's returns to make the filing process easier. The best programs ask you a series of simple questions to identify deductions and credits you're eligible for and to make sure you claim all your income.
If you decide to use an accountant or get help from a tax professional, ask about their credentials and experience. Hire someone who has done taxes for a long time and who is familiar with situations like yours. Steer clear of services offering tax-refund loans and of companies that provide cash in advance of your refund, as these usually charge very high fees. If you have to pay for tax help, it may seem like a big expense, but it's far less costly to get advice than it is to deal with an audit or to miss out on thousands of dollars in deductions or credits.
10. Not filing or not paying taxes on time
Finally, one huge tax mistake is failing to file your taxes or failing to pay them on time.
Filing your taxes on time is absolutely essential, even if you can't pay everything you owe right away. The penalty for failure to file is much higher than the penalty if you simply fail to pay.
- If you fail to file, you pay a penalty of 5% of taxes you owe for each partial month you're late. The maximum penalty is 25% of the taxes owed. If you miss the deadline by more than 60 days, the maximum penalty is the lesser of 100% of the unpaid taxes or $205. Missing your deadline by just a few days could lead to a big penalty. If you owed $1,000 and were three days late, this could trigger a $50 penalty.
- If you fail to pay, you owe a penalty of .5% of the taxes you owe for each partial month you're late. The maximum penalty is 25% of the taxes you owe. There's an exception, though. If you pay 90% of taxes due, request an extension, and pay the remaining 10% by the extended deadline, you won't have to pay a penalty.
- If you both fail to file and fail to pay, the maximum penalty is 5% of unpaid taxes for any part of a month in which you owe both penalties. This is the same penalty as the failure-to-file penalty.
Obviously, a 5% penalty if you don't file is much bigger than a .5% penalty if you don't pay on time. So even if you can't pay, you should still file a return.
If you can't file a return by tax day -- which is April 15, or the next business day if the 15th is a holiday or weekend -- request an extension with the IRS by submitting Form 4868, the Application for Automatic Extension of Time to File U.S. Individual Income Tax Return. You can get an extension until October 15 or the next business day.
But the extension is only an extension of time to file -- not an extension of time to pay. You'll still owe penalties and interest if you don't pay by the April deadline, unless you've paid 90% of what's owed and pay the rest by the extended deadline. No matter what, always file on time. And if you expect to owe, try to save during the year so you have the money by April, when it's due.
Don't make these 10 tax mistakes
Now you know how to avoid some of the most common tax mistakes. It's worth taking the time to avoid these errors and to do your taxes correctly so you don't trigger an audit, owe penalties, or pay more than is necessary to the IRS.