Nobody likes paying taxes, and you should never pay any more in taxes than you truly owe. Yet millions of taxpayers routinely do things that lead to higher tax bills than are necessary. The sad thing is that many of these mistakes are completely avoidable with only a minimum of effort.
Knowing the most common mistakes is the first step toward making sure your taxes are as low as possible. Let's go through some of the most costly tax mistakes people make and how to avoid them.
1. Selling winning investments before lower tax rates kick in
It's always nice to have a winning stock, and many people like to sell their winners and lock in their gains before market volatility takes them away. That can sometimes be the prudent move from an investing standpoint, although often, selling winners quickly only leads to missing out on even larger gains over the long term.
From a tax perspective, there's a definite cost to selling winners quickly. If you've held a stock for just one year or less, then you'll pay ordinary income tax rates on the gain, which can cost you as much as 37% in taxes under current law. Hold the stock for longer than a year, though, and long-term capital gains rates kick in, ranging from 20% all the way down to 0% for some taxpayers.
2. Not using accounts that have tax advantages
There are many different types of investment accounts that can give you big tax breaks. Traditional IRAs and 401(k) accounts let you reduce your taxable income now, while the Roth versions of those accounts give you a chance to generate tax-free income throughout your lifetime. For educational expenses, 529 plans and Coverdell ESAs offer benefits that will reduce your eventual tax bills while helping to pay for college and related expenses. Health savings accounts play a similar role for healthcare expenses, letting you make tax-deductible contributions and avoid tax on gains when using the money for covered medical services.
Everyone qualifies for at least some of these accounts, and not using them results in higher tax bills. Look closely at the options available to you and choose the ones that work best for your situation.
3. Not choosing the right investments for the right account
Having tax-advantaged accounts by itself isn't enough. You also have to use them well. For instance, keeping high-income investments in a regular taxable account while putting other investments in a tax-deferred account can result in only modest tax savings. By contrast, if you put those high-income investments in the tax-deferred account, the savings can be a lot higher. In particular, because all distributions from traditional IRAs and 401(k)s are subject to tax at ordinary rates, a stock that appreciates in value considerably can result in more tax in a retirement account than you'd pay in capital gains in a regular taxable account. By putting appropriate investments in each type of account, you'll minimize your tax bill both now and in the future.
4. Failing to pay required estimated taxes
The IRS requires you to have enough money withheld from your paychecks to cover most of your tax bill. If your withholding doesn't amount to at least 90% of your total tax liability and your taxes owed will exceed $1,000, then you'll typically have to make quarterly estimated tax payments to avoid costly interest and penalties.
To fix this, you can do one of two things. Making estimated tax payments isn't difficult and will solve the problem, but if you'd rather not do that, you can also boost how much money gets withheld from your paycheck. If you can raise your withholding to get within the 90% or $1,000 limits, then you won't get in trouble for not paying estimated taxes throughout the year.
5. Not maximizing tax deferral opportunities
Beyond using tax-advantaged accounts, the simple rule to minimize taxes is to take deductions as soon as possible and defer income as long as possible. Strategies like tax-loss harvesting can help you accelerate deductible losses. For income, decisions like avoiding sales on winning investments or not withdrawing as much money from a tax-deferred retirement account in a given year can help you cut your tax bill as well. In general, the longer you can avoid tax, the better off you'll be.
6. Thinking that not filing a required return is smart
Many people in financial straits can't afford to pay their taxes, and they therefore decide that they shouldn't bother filing a return. That can be a huge mistake, because the penalties for failing to file a return are 10 times greater than the penalty for not paying tax due. Failure to file penalties add up at a rate of 5% per month, so the smart thing to do is to go ahead and file a return while trying to make arrangements with the IRS to handle payments in a manner you can afford.
7. Failing to keep necessary tax records
The worst thing about a tax audit is when you don't have the records you need to support the positions you took on your return. For example, on items like charitable gifts, it's essential to have an acknowledgement of your donation from the charity to take it as an itemized deduction.
The IRS can generally go back three years to audit tax returns, with longer periods applying in cases of fraud or large amounts of underreported income. Keeping tax returns, supporting statements, and other documents is crucial just in case auditors come calling.
Don't make these mistakes
Fortunately, these mistakes are pretty easy to avoid. The key is being aware of the potential problem in the first place. Once you know how common these missteps are, you'll be motivated to cut your own tax bill by taking action now.
The Motley Fool has a disclosure policy.