Nine Tax Pitfalls and How to Avoid Them

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All it took was a quick glance at the young woman’s federal tax return form for Certified Financial PlannerAustin Lewis to spot an important omission — one that could net the college student a valuable $2,500 American Opportunity Tax Credit from Uncle Sam – and avoid a costly tax pitfall.

 

Fortunately this young woman consulted Lewis before filing her tax return, preventing her from succumbing to one of the many common and potentially costly pitfalls that can trip up taxpayers. With the tax deadline fast approaching, here’s a look at some of those pitfalls and how to avoid them:

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  1. Failure to consult a tax advisor. As much as the adage “You don’t know what you don’t know” seems like a useless tautology, it certainly applies to the tax filing process, where the nuances, complexity and changeability of the tax code make it vital for most taxpayers to consult a tax expert — someone with the know-how to spot omissions and potential red flags, to fix errors, to uncover tax benefits and generally to help a person get the most out of the tax hand they are dealt. “It’s important to meet with a tax professional earlier rather than later in the tax season,” asserts Lewis, founder of Rooted Financial Planning in Fort Worth, Texas, “so you have the benefit of time to analyze and prepare.” He suggests asking friends, family, etc., to recommend a tax professional who is willing to invest time to learn about their clients’ circumstances, for a reasonable fee.

 

  1. Waiting until the last minute to prepare and file tax returns. Hurriedly filling out and filing tax returns just before the filing deadline (typically April 15) invites errors, omissions and other problems that could come back to haunt you. It also doesn’t allow time to plan how to pull together money to pay the taxes you owe. And missing the filing deadline altogether may result in a substantial penalty from the IRS (and from the state in which you file).

 

  1. Withholding too much or too little from earnings. Many employees rely on their employers to automatically withhold money from their paychecks to cover income tax. Usually the amount the employer withholds is dictated by a person’s earnings, and by the information they provide the employer on their W-4 tax form about their filing status (single or married) and other withholding “allowances,” such as dependent children. The more allowances a person claims, generally speaking, the less their employer will withhold for taxes.

Trouble can arise when the information on a W-4 causes either too much or too little to be withheld by claiming not enough or too many allowances. The latter situation can be particularly sticky, says Lewis. “If you under-withhold, chances are you are going to owe more taxes than you expect.” And in the case of withholding too much, while that probably means you have a better chance of getting a tax refund, that’s money you could have used for more constructive purposes, like contributing to a retirement account, saving for college or paying down debt, he notes.

To avoid over- or under-withholding, check the W-4 form your employer has on file for you to verify the allowances accurately reflect your current situation. And when your situation changes — a salary increase, birth of a child, change in marital status, etc. — be sure your employer adjusts your allowances and withholding accordingly. For help figuring out what’s appropriate withholding, check out the IRS calculator at www.irs.gov/Individuals/IRS-Withholding-Calculator

 

  1. Needlessly waving a red flag at the IRS. Certain items in a person’s (or business’s) tax returns tend to garner unwanted attention — and, perhaps, an unwanted audit — from the IRS, according to Lewis. Those include:
  • claiming an excessive amount of work-related vehicle mileage relative to income.
  • claiming an inordinately large proportion of a home’s square footage as home office space.
  • claiming business losses over an excessive period of years.

  1. Forgetting to report retirement account contributions. If you save into a tax-qualified individual retirement account or a 401(k), be sure to report the amount you’ve saved into those accounts, as it will lower your amount of taxable income, and thus, perhaps, your overall tax tab. Your contribution amount should be reflected in the year-end statement supplied by the company that manages your retirement account or plan.

 

  1. Overlooking tax credits that you’re eligible to claim. Many taxpayers make the same mistake as the aforementioned young woman who was eligible for the education tax credit, overlooking tax breaks for which they eligible — breaks that can make a significant difference on their tax returns. So if you’ve done things like paid for a college education, purchased energy-efficient equipment or an electric vehicle, if you’ve saved money toward retirement, you could be eligible for tax credits and the like. Here again, a tax specialist who asks the right questions can help uncover those that may apply to you.

  1. Not looking over the prior year’s tax return. Be sure always to look back at your tax returns from the previous year, Lewis says, so you don’t miss things like capital losses that can carry over from the prior year.

 

  1. Taking a standard deduction when it would have been better to itemize deductions, or vice versa. Most taxpayers have a choice of filing with a standard deduction or itemizing their deductions. Their tax returns — and the amount they either must pay or get back as a refund — can differ substantially depending on which approach they use. If you qualify for deductions that exceed the amount of the standard deduction, it may be worth filing a return with itemized deductions. Be sure to consult a tax expert to determine which route is best for you.

 

  1. Failing to report income or loss from investment transactions. The proceeds from the sale of stock, for example, must be accounted for on your tax returns. Failing to do so could result in a major tax hit. This applies mostly to transactions involving taxable investments, not to those involving assets in tax-qualified accounts such as 401(k)s and traditional IRAs.

This column is provided by the Financial Planning Association® (FPA®) of Northeastern New York, the principal professional organization for Certified Financial PlannerTM (CFP®) professionals. FPA is the community that fosters the value of financial planning and advances the financial planning profession and its members demonstrate and support a professional commitment to education and a client-centered financial planning process. Please credit FPA of Northeastern New York if you use this column in whole or in part.

The Financial Planning Association is the owner of trademark, service mark and collective membership mark rights in: FPA, FPA/Logo and FINANCIAL PLANNING ASSOCIATION. The marks may not be used without written permission from the Financial Planning Association.

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