Owing taxes is one thing, but when there are penalties and interest tacked on due to errors that could have been avoided, that’s painful. To save money, some people prefer to prepare their own taxes. If you know what you’re doing, that’s great; however, if you don’t, you could make costly errors. 8 common tax mistakes people make that cost them money are as follows:
1. Under-Reporting Income
Under-reporting income is a costly common mistake that self-employed individuals tend to make; however, some general taxpayers are guilty of doing this as well. Whether under-reporting income is really a mistake, well, that’s open to interpretation. So what is under-reporting of income? Under-reporting income is simply when a person does not report all of their income to the IRS. Why is under-reporting income bad? Simply put, doing this can cause you to have to pay more money to the IRS and state taxing agencies in the form of penalties and interest. In case you’re not aware of this, when you receive a Form W2 or a 1099-Misc, the payer mails a copy to the IRS and state taxing agency (if applicable). So, if you’re thinking about not reporting that 1099-Misc income for the year, think again. Under-reporting your income will eventually cost you.
Penalties imposed by the IRS for under-reporting your income will depend if the IRS considers the under-reporting to be negligence or tax fraud. A careless mistake on your tax return will cost you 20% of the additional tax due, whereas, if the under-reporting is considered fraud, you’re looking at a 75% penalty. Is it worth it to under-report income? With these percentages, I don’t think so.
2. Over-Stating Deductions
Cheating on your taxes? Well, if you over-state your deductions, that’s exactly what you are doing? At some time or another, nearly every taxpayer has likely over-stated a deduction or two, or three. Why would a person over-state a deduction? Simply put, to reduce their taxable income. While inflating a deduction here or there may seem harmless, if you’re caught, it’s going to cost you. Not only will that deduction be denied, but you will likely get hit with an Accuracy Related Penalty. Yes, there is such a penalty. What exactly is the Accuracy Related Penalty? The Internal Revenue Code (IRC) §§ 6662(b)(1) and (2) authorizes the IRS to impose a penalty if a taxpayer’s negligence or disregard of rules or regulations caused an underpayment of tax, or if an underpayment exceeded a computational threshold called a substantial understatement, respectively.
3. Retirement Fund/Early Distribution
To discourage the use of retirement funds for purposes other than normal retirement, the IRS imposes a 10% additional tax on certain early distributions from certain retirement plans. The additional tax is equal to 10% of the portion of the distribution that is includible in income. Generally, early distributions are those you receive from a qualified retirement plan or deferred annuity contract before reaching age 59½. The term qualified retirement plan means:
• A qualified employee plan under section 401(a), such as a section 401(k) plan
• A qualified employee annuity plan under section 403(a)
• A tax-sheltered annuity plan under section 403(b) for employees of public schools or tax-exempt organizations, or
• An individual retirement account under section 408(a) or an individual retirement annuity under section 408(b) (IRAs)
In general, an eligible state or local government section 457 deferred compensation plan is not a qualified retirement plan and any distribution from such plan is not subject to the 10% additional tax on early distributions. However, any distribution attributable to amounts the section 457 plan received in a direct transfer or rollover from one of the qualified retirement plans listed above would be subject to the 10% additional tax.
4. Failure to File a Tax Return
Failing to file a tax return could cost you.
A failure-to-file penalty may apply if you did not file by the tax filing deadline. A failure-to-pay penalty may apply if you did not pay all of the taxes you owe by the tax filing deadline.
The failure-to-file penalty is generally more than the failure-to-pay penalty. You should file your tax return on time each year, even if youâ€™re not able to pay all the taxes you owe by the due date. You can reduce additional interest and penalties by paying as much as you can with your tax return. You should explore other payment options such as getting a loan or making an installment agreement to make payments. The IRS will work with you.
The penalty for filing late is normally 5 percent of the unpaid taxes for each month or part of a month that a tax return is late. That penalty starts accruing the day after the tax filing due date and will not exceed 25 percent of your unpaid taxes.
5. Underpayment of Estimated Taxes
If you did not pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax. Generally, most taxpayers will avoid this penalty if they either owe less than $1,000 in tax after subtracting their withholding and estimated tax payments, or if they paid at least 90% of the tax for the current year or 100% of the tax shown on the return for the prior year, whichever is smaller. There are special rules for farmers and fishermen, certain household employers and certain higher income taxpayers.
6. Excess IRA Contributions
An excess IRA contribution occurs if you:
• Contribute more than the contribution limit.
• Make a regular IRA contribution to a traditional IRA at age 70½ or older.
• Make an improper rollover contribution to an IRA.
Excess contributions are taxed at 6 percent per year as long as the excess amounts remain in the IRA. The tax can’t be more than 6 percent of the combined value of all your IRAs as of the end of the tax year.
7. Failure to take RMD
What does RMD mean? RMD is short for Required Minimum Distribution. That nest egg can’t grow forever. When you reach the age of 70½ years old, the IRS requires that you start taking distributions from your qualified retirement accounts. A stiff penalty applies if you don’t take a RMD when you are required to. The penalty amount for not taking a RMD is a whopping 50 percent tax on the amount not withdrawn in time. Wouldn’t you rather to keep that 50 percent instead of giving it to the IRS?
There is an exception to this rule: If you’re still working, you can generally delay RMDs, but only from the retirement plans you participate in with your current employer. In these situations, your first distribution must be made by April 1 of the year following the year of your retirement.