7 tax misunderstandings that could cost you


"Next to being shot at and missed, nothing is really quite as satisfying as an income tax refund."
-- F.J. Raymond

While we can't know everything, there are some things that will cost us if we don't know them. Tax misunderstandings offer one such example. With this in mind, here are seven tax misunderstandings to set yourself straight about:

1. You shouldn't necessarily want a fat tax refund

For starters, while it's wonderful to get a hefty check from Uncle Sam after filing your tax return, that's not really such a great thing. After all, it's technically your own money that you're getting back, and the government has been hanging onto it until you filed your return. Modest refunds are common and not a problem, but big refunds generally happen when we have too much withheld from our paychecks. You can adjust your withholding by submitting another W-4 form to your employer.

2. Tax credits are more valuable than tax deductions

Tax credits and deductions aren't the same thing. Both offer tax breaks, but tax credits are more powerful.

A deduction reduces your taxable income. Have gross income of $70,000 and a $4,000 deduction? Your taxable income is now $66,000. If you're in the 25% tax bracket, you avoid being taxed on that $4,000 and save $1,000. If you have taxable income of $70,000 and a $4,000 tax credit, however, the credit reduces your tax dollar-for-dollar. It's worth a full $4,000.

Credits are available for all kinds of things, such as education expenses, the adoption of children, and the care of children and dependents. A particularly valuable credit, if your income is low enough to qualify, is the Earned Income Tax Credit, which might shrink your taxable income by more than $6,000. The Child and Dependent Care Credit offers a credit of up to $3,000 for the care of one eligible dependent and up to $6,000, total, for two or more.

See a guide to the commonly-used tax forms:

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Guide to commonly-used US tax forms
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Guide to commonly-used US tax forms

The 1040 family of tax forms is for federal income tax and is absolutely essential for all.

The 1040EZ form is the simplest version and is typically filed by those who:

  • Have no dependents
  • Are younger than 65
  • Earned less than $100,000
  • Don’t plan to itemize deductions

Form 1040A is more comprehensive than 1040EZ, but simpler than the regular 1040. It's beneficial for those who earn less than $100,000 and don’t have self-employment income -- but who want to make adjustments to their taxable income, such as child tax credits or deductions for student-loan interest. Note that it doesn't allow for itemized deductions.

Form 1040 is filled out by those who make $100,000 or more, have self-employment income or plan to itemize deductions.

The W-2 is completed by employers document each employee's earnings for the calendar year. You will want to take a look at this tax form for important information you'll need to fill out your 1040, 1040A or 1040EZ. 
The 1098 form is filled out by those who:
  • paid interest on a mortgage
  • paid interest on a student loan 
  • paid college tuition
  • donated a motor vehicle to charity

The 1099 series is reports all income that isn’t salary, wages or tips, and must be reported on both the state and federal level.

1099-DIV reports dividends, distributions, capital gains and federal income tax withheld from investment accounts, including mutual fund accounts.

1099-INT trakcs interest income earned on investments.

1099-OID (Original Issue Discount) is provided if you received more than the stated redemption price on maturing bonds.

1099-MISC documents self-employment earnings, as well as miscellaneous income such as royalties, commissions or rents. It covers all non-employee income that is not derived from investments.

If you receive a refund that you're unable to pay in full, you can request a monthly installment plan using Form 9465.
Don't forget to notify the IRS if you move! Use Form 8822 to change your address with the Internal Revenue Service. Otherwise, notices, refunds paid with a paper check and other correspondence relating to your personal, gift and estate taxes will be sent to your former address.
Anyone who has been employed by a company has completed a Form W-9. The W-9 is used by employers for payroll purposes -- and the information on the W-9 is used to prepare employee paychecks during the year and W-2 forms at the end of the year. 
The W-4 is an IRS form completed for employers know how much money to withhold from your paycheck for federal taxes. Accurately completing your W-4 can both ensure you don't have a big balance due at tax time and also prevent you from overpaying your taxes.
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3. You do have to report all income

It can be easy to think that you only have to report income to the IRS that you get documentation for in the mail -- such as via a W-2 form or a 1099 form. Not true. You need to report all income, from rental income to prize money to gambling winnings. If you get paid in cash for some or all of the work you do, that, too, needs to be reported.

You should report all income because it's the right thing to do, but also because the IRS may already know about some income you're not reporting, and it will wonder why you're not reporting it. After all, entities that pay you will very often be reporting that expense to the IRS.

4. You can't get an extension for paying your taxes

Many people misunderstand the nature of a tax extension. When you file IRS Form 4868 for an extension, you are only postponing the filing of your return. You can't postpone paying the taxes that are due. That might sound tricky, as you may not know exactly how much you owe if you haven't yet completed your return, but the IRS expects you to make a good-faith estimate and pay that amount. (If you think your total taxes due will be around $15,000 and $12,000 was withheld by your employer, you would send in the difference, $3,000.)

The IRS imposes penalties for filing a late return and for paying taxes late. Penalties can be as much as 25% of the tax owed and the unpaid tax. Even if you can't pay, file your return. And if you can pay at least some of what you owe, do so, to minimize the penalty hit.

5. You can reduce your chances of being audited

Your chances of being audited are very low -- and were recently less than 1 in 100. Don't think it's all a matter of chance, though, because there are factors that can make an audit more likely. For example, if you have earnings that are well above average, you'll be more likely to have your return audited. If you're self-employed, you'll be more likely to be audited, as well, because it can be easier for a self-employed person to fudge numbers than it is for a salaried person.

Factors more under your control that can keep your audit odds low include being neat and legible when filling out your return, reporting all income on it (including all dividends and interest that's reported on 1099 forms), and not having math errors on it that will draw the attention of the IRS. If you report having no income at all, the IRS might question that -- which is not a problem if you really did have no income. It may also question bigger-than-usual deductions such as for charitable donations or business expenses. Again, such deductions might get you audited, but they won't cause much trouble if they're legitimate and you have documentation to back them up.

6. You have rights as a taxpayer

You might feel powerless against the IRS, but you do have rights. There is a Taxpayer Bill of Rights that was adopted by the IRS in 2014, assuring us the right to be informed, the right to quality service, the right to pay no more than the correct amount of tax, and the right to challenge the IRS, among others

There's even a Taxpayer Advocate Service, headed by our "National Taxpayer Advocate," Nina Olson. Ms. Olson regularly informs Congress of problems she sees in our tax system and makes recommendations for fixing them. Her office also helps thousands of taxpayers with various problems every year.

7. The IRS will not phone you

Finally, the IRS is never going to call you out of the blue -- and it won't send out unsolicited email, either. If you receive a phone call, as many people have, from someone saying they're with the IRS and that they need you to make a payment immediately or they need your Social Security number or bank account or credit card numbers, don't believe them. There are many tax scams out there bilking taxpayers out of money.

Getting your personal information can help a scammer engage in identity theft -- filing a tax return in your name and collecting a refund. The IRS is aware of and has been tackling this problem, and in fiscal year 2015, it initiated 776 identity theft related investigations, resulting in 774 sentencings. Working behind the scenes, in the first nine months of 2016, it reduced the number of people who filed affidavits with the IRS saying they were victims of identity theft by almost half, compared to 2015 -- with affidavits dropping from 512,278 to 237,750. Still, be warned and be wary.

Be savvy about the IRS and how our tax system works, and you can save yourself headaches -- and possibly hundreds or thousands of dollars.

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