April 15th is just around the corner and in the U.S. that means tax filing deadline. If you haven’t already filed (and I’m guessing most of my readers have), you are rapidly running out of time to get those taxes prepared and filed with the IRS.
Unfortunately, good tax planning doesn’t happen when you are ready to file your taxes, it happens in the 12 months before tax time. Now that 2012 is almost history (as far as taxes are concerned), take some time now to ensure that you are properly positioned for your 2013 tax returns next April.
By far the best way to lessen the pain of tax season is to avoid making mistakes during the tax year. Below you will see eight tax mistakes that cause taxpayers to shell out hundreds or thousands of dollars more than necessary. Remember, you are obligated to pay your taxes, but you are in no way required to overpay!
- Losing Out on Tax Favored Account Savings – The IRS provides tax payers with a number of tax advantaged accounts that allow you to minimize your tax burden now and far into the future. Among them are 401(k)’s, individual retirement accounts (IRAs), 529 and Coverdell plans for education, health savings accounts and flexible spending accounts. Using these plans appropriately can literally save you thousands of dollars in taxes now, and thousands more in the future when you are ready to use the proceeds of the accounts. When you choose not to use these tax favored accounts, you are handing money over to the government needlessly.
- Liquidating Investments Too Soon – Capital gains taxes on many investments vary depending on how long you hold the investment. If you sell before you’ve held the investment for a full year, you are liable for taxes at your normal rate, which could be as high as 39.6 percent in 2012 according to my tax calc. Waiting until you’ve held the investment for longer than a year makes it eligible for long term capital gains rates which are currently just 20 percent and some tax payers may have investments in which the tax on their gains is 0 percent.
- Failing to Pay Quarterly Estimated Taxes – This mistake is most common for sole proprietors and those who perform work outside a normal company that withholds taxes. The U.S. income tax is considered a pay as you go tax, meaning taxes on income and earnings need to be paid as they are realized. If your tax bill at the end of the year is greater than $1000 the IRS considers you to have underpaid during the year and you will be subject to penalties on the late payments. If you are in doubt about your tax burden, download a copy of the 1040-ES form and calculate how much you should be paying in taxes, then send a quarterly payment to the IRS if it looks as if you are underpaying.
- Putting Investments or Assets in the Wrong Type of Account – Some investments are actually not suitable to be held in tax advantaged accounts. Stocks that will be held for more than a year, many state and municipal bonds, and master limited partnerships (MLPs) come immediately to mind as asset classes that may be better held outside of a tax advantaged account. On the other side of the coin are real estate investment trusts (REITs), which are typically taxed at the much higher ordinary rates and are better suited to a tax advantaged account. Simply put, don’t place asset that are already tax advantaged into a tax advantaged account.
- Bad Timing for Losses and Income – Often when it comes to taxes, timing is everything. Timing your deductible expenses, harvesting tax deductible losses and deferring taxable income are all savvy tax moves. For example, with tax rates rising for 2013, many taxpayers did their best to realize income in 2012 and leave deductions for 2013 to minimize their 2013 tax bill because tax rates will be higher.
- Not Paying Attention to Special Tax Rules – The U.S. tax code is extremely complex and has many special rules and exceptions. When selling stocks and other assets, you should be fully aware of the tax treatment of those assets to avoid selling them too soon or at the wrong time. For example, if you sell shares of stock too soon after receiving a dividend you lose the lower tax rate on the dividend payout. Learn the tax rules regarding all your investments and assets, or hire a tax planner who can help.
- Incomplete Record Keeping – Any deductions taken on your tax returns need to be backed up with the proper documentation in the event of an audit. One common example is charitable donations, which require an acknowledgement letter showing the amount of your donation and stating that you received nothing of value in return. IN the case of large donations or gifts you may also need an appraisal.
- Failure to File – Even if you don’t have the money to pay your tax obligations you shouldn’t fail to file a return. Failure to file comes with penalties that are 10 times as large as the penalties for filing and failing to pay your tax obligation on time. And if you don’t have the money to pay now, you can always request an extended payment plan.
Depending on your tax circumstances there are many other mistakes that can be made, these are just a few (after all, the tax code contains over 17,000 pages). One of the unfortunate side effects of having money is the increasing complexity of how to properly manage that money. I guess it’s a good problem to have though, if you must have problems. If your taxes are becoming increasingly complex your best bet might be to hire a tax professional, however in most cases as long as you keep good records and research any special circumstances you face you can prepare your own return.
What about you? Are you aware of any special tax circumstances that could lead to someone overpaying their tax bill? Comments welcome below!