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What You Don't Know About Your Taxes Could Cost You

By Dan Caplinger - Apr 26, 2017 at 9:09AM

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Don't get stuck in these tax traps.

Taxes are complicated, and there's probably no one on Earth who knows everything there is to know about taxes. But you owe it to yourself to know as much about your tax situation as possible, because it's your hard-earned money at stake. In particular, there are several tax traps that snare millions of taxpayers each year, and they can cost you a lot of money as well as causing needless headaches. Fortunately, it's easy to avoid these mistakes as long as you know about them.

1. Can't pay? File anyway

The tax filing deadline was a couple weeks ago, and if you didn't request an automatic extension on or before April 18, then you're already on the clock with the IRS. The reason why many taxpayers don't file or ask for an extension is that they know they can't afford to pay their tax bill, and so they hope to fly under the IRS' radar. But that won't work, and it's far more costly than filing even if you can't pay.

The penalties for not filing your tax return are 5% of the tax you owe for every month or part of a month you're late in filing. By contrast, the penalty for being late in paying your taxes is just 0.5%, or a tenth of the late filing penalty. Given the futility of trying to hide from the IRS, it's best to file with an explanation that you won't be able to pay, and then work on getting your taxes paid down when you can.

Keyboard with blue tax button.

Image source: Getty Images.

2. Marginal tax rates don't apply to your entire income

A lot of people pay close attention to their marginal tax rate, and it is an important measure to keep in mind. Marginal tax rates tell you how much in taxes you'll pay if you decide to earn additional income, and as your income goes up, your marginal tax rate tends to rise as well under the federal government's progressive tax structure.

Yet a key mistake people make is to think that they need to avoid rising into a new marginal tax bracket because they'll pay a huge amount of additional tax. That's not the case, because the marginal rate doesn't necessarily apply to all of your income but rather just to the last dollar you earned. For instance, if the tax rate was 10% on earnings up to $10,000 and 25% above that amount, then you wouldn't pay 25% in taxes if you earn $10,001. You'd pay 10% of $10,000 plus 25% of the incremental $1, or a total of $1,000.25. As a result, you shouldn't let marginal tax rates stop you from taking on income-earning opportunities.

3. Don't miss out on tax breaks

A shocking number of taxpayers don't claim tax credits, deductions, and other breaks that could save them thousands on their taxes. Some of them are simple, such as choosing the most favorable filing status for which you qualify. Others involve simply knowing about a tax break. For example, the IRS estimates that roughly one in five taxpayers who qualify for the earned income tax credit don't claim it. With a maximum topping out just above $6,250 -- and eligible for return to taxpayers as a refund, even if you don't have enough tax liability to need the entire credit -- leaving the earned income credit unclaimed is a colossal error. Many other deductions, credits, and other favorable provisions similarly go untapped.

Not everyone will be able to unearth found money by looking more closely at the credits and deductions available to all taxpayers. But just learning about those favorable tax provisions can help you manage your taxes more effectively next year, and that could be just what you need to reduce your taxes in the long run.

4. You might not even have to file your taxes if your income is low enough.

The threshold for having to pay taxes is higher than many people realize. In 2016, joint filers could make up to $20,700 in gross income without filing, and singles come in at half that figure. Heads of household must file if gross income exceeds $13,350.

Even among those who have to file, deductions are often sufficient to zero out their tax liability. Yet these low-income taxpayers still often pay substantial payroll taxes to fund Social Security and Medicare. These payroll taxes are withheld directly from paychecks, and although provisions like the earned income credit are designed in part to return that payroll tax revenue, the fact remains that even though taxpayers tend to be most scared of the income tax, it's not always the most important thing that they have to pay.

Taxes are complicated, and these are just a few of the provisions that can be tricky. By knowing about them, you'll do a better job of steering the right path and paying the least in taxes that you legally can.

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