The federal tax code is hideously complicated. Even tax experts aren't always sure what some of the more obscure provisions really mean. So it's no surprise that a number of myths have sprung up about how taxes work. Here are some of the most common myths -- and why you shouldn't believe them for a second.
"Only rich people get audited"
If you think you're safe from an IRS audit because you make under seven figures, think again. It's true that IRS auditors tend to focus on individuals with $1 million or more of annual income because they're more likely to be able to squeeze out a significant amount of extra taxes from high-income taxpayers. But lower-income returns sometimes come under fire too, depending on what's on your return. For example, taxpayers with reported income under $25,000 who claimed the Earned Income Tax Credit were audited twice as often as the average individual taxpayer in 2014.
Because of IRS budget cuts and resulting rounds of layoffs, overall audit rates have dropped to embarrassingly low percentages. But as the IRS continues to automate more functions, the agency will become able to flag more sketchy returns and pick up on unreported income without human intervention. And just because your return was accepted without a murmur doesn't mean you're safe: the IRS can audit you for up to three years after the tax year in question (or six years if you omitted 25% or more of your income from the return).
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"I don't need to report cash income"
Some taxpayers with cash income believe that since there's no paper trail of the payment, they can safely leave that income off their tax return. If you're one of these taxpayers, think again: the IRS has several methods to detect unreported income, and if they catch you using these methods, you'll be in serious trouble.
For example, there's T-account analysis, which the IRS used to put Al Capone away. The agency compares your reported income to your expenses to see if said income was equal to or greater than the money you spent. If not, they'll come knocking on your door to find out where the extra money came from. IRS agents can also add up your bank account deposits, compare reported self-employment income to the average income from similar businesses, and track your Internet and e-commerce activities. In short, if you have a large amount of unreported income -- cash or otherwise -- sooner or later the IRS will find out.
"I don't need a Roth IRA because I'll have lower income once I retire"
With a traditional IRA or 401(k), you receive a tax break on the money you contribute to the account; with a Roth account, you instead receive a tax break on the money you take out. This particular myth arose because if you're in a higher tax bracket when you contribute the money than you expect to be when you take it out, your tax savings in this regard would be higher with a traditional account versus a Roth account.
However, the distribution tax break is not the only tax benefit of having a Roth IRA. For example, Social Security benefits become taxable if you have enough other sources of taxable income in retirement to hit a certain threshold. The distributions from a traditional IRA or 401(k) account as taxable income, so if that's where the bulk of your retirement income is coming from, your Social Security benefits are likely to be taxed. On the other hand, Roth distributions are not taxable income, so having a Roth account in addition to or instead of a traditional IRA can keep your Social Security benefits from being taxed.
Another significant perk of Roth accounts is that they're not subject to required minimum distributions, so they can protect you from having to take extra money out of your retirement savings accounts (and pay extra taxes as a result). All in all, having at least some of your money in a Roth account can cut your taxes significantly regardless of how high your retirement income is.
"It doesn't matter who I hire to do my tax return"
It would be nice if everyone who called themselves a tax preparer was qualified. Unfortunately, that's not always the case: barring a few states such as California and New York, there are no experience or education requirements for tax preparers. And even in those states that have qualification requirements, the requirements can be pretty basic. For example, California tax preparers have to take a 60-hour course to qualify and do 20 hours of continuing education in subsequent years -- but there's no experience requirement. And needless to say, having an unqualified person prepare your tax return not only means you may pay more in taxes than necessary, it can also land you in hot water with the IRS.
If you have anything more complicated than a 1040-EZ, seek out a credentialed tax preparer such as an enrolled agent or CPA. Enrolled agents don't have experience requirements, but we have to pass a hideously complicated three-part IRS exam that guarantees we know our stuff. CPAs have both education and experience requirements to become certified. And both enrolled agents and CPAs have ongoing continuing education requirements. It's true that you'll likely have to pay a bit more to get a credentialed tax preparer's help (although enrolled agents typically charge about half what CPAs do), but if your credentialed preparer spots an extra tax break or two and adds them to your return, you'll likely save enough on taxes to cover the fees. And if you should run into IRS trouble, both enrolled agents and CPAs can represent you before any department of the IRS, including auditors, collections agents, and appeals officers. Being able to shove the hassle of dealing with the IRS off onto someone else is enough by itself to make those extra fees worthwhile.
