With some basic knowledge and planning, you can take simple steps to avoid costly tax errors. Avoiding the mistakes cited below will save you money.
1) Ignoring the Alternative Minimum Tax (AMT)
The AMT is a separate income tax system with its own set of rules. Basically, you have to figure your tax bill two ways . . . and pay the higher amount.
In the world of the AMT, many valuable deductions are not allowed, including the deduction for state and local income taxes, property taxes, car license fees, certain home-equity loan interest paid, a portion of your medical expenses and most miscellaneous itemized deductions (such as income tax preparation fees and employee business expenses).
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- If a significant portion of your miscellaneous itemized deductions happens to be employee expenses you're not reimbursed for, check with your employer to see if you can be reimbursed directly for your costs.
- Don't assume that it's always best to prepay your state income taxes or your property taxes before the end of the year. If you are subject to the AMT, neither of these expenses is deductible.
For More Read: Beware the AMT
2) Ignoring Entitled Tax Deductions
Take charitable contributions into consideration. You may not think the clothes you give to charity are worth much, but consider using valuation software and see how much items actually sell for when determining how much to claim. You may be surprised. At the same time, note that the law now says you can't deduct anything unless the clothes are in good condition or better.
Also, keep track of out-of-pocket expenses you incur while working for a charity -- the cost of stamps you buy for a fundraising mailing, for example, or the cost of ingredients for food prepared for a church soup kitchen. Add those costs to your cash contributions when toting up your deduction.
Some taxpayers who work out of their homes steer clear of home-office deductions for fear that such write-offs plant a red flag on their return, begging for an audit. That's silly. If you legitimately deserve such deductions, claim them.
Visit Our Taxopedia: What's Deductible?
3) Not Accounting for Mutual Fund Dividend Reinvestments
Each time you reinvest dividends, you buy extra shares in the fund. Be sure to add the cost of those shares to your tax basis when you calculate your taxable gain from a sale. Otherwise, you will overpay the IRS. If your fund tracks the average basis of shares for you, it will automatically include reinvested dividends in the calculation; otherwise it's up to you.
4) Failure to Track Year-to-Year Carryover Items
If you paid state and local taxes when you filed your 2006 state tax return in 2007, remember to include that amount in your 2007 state and local tax payments. In addition, if you had capital losses in a prior year in excess of the $3,000 annual deduction limit, be sure to carry the unused losses over to your 2007 income tax return. The same goes for any charitable contribution you couldn't deduct in a previous year because of limits on such write-offs. Don't let such carryovers get lost in the shuffle.
5) Failing to Name (or Naming the Wrong) Beneficiary to Your Retirement Plan
When you die, your IRA, 401(k), or other qualified retirement plan account passes to whoever you have designated as the beneficiary. In many cases, that will be your spouse. But if you designate no beneficiary, the money may go to your estate. If that happens, your heirs are required to clean out the account over a five-year period instead of over their life expectancy, which greatly accelerates the taxes they owe. And naming your grandchildren as beneficiaries may trigger the generation-skipping transfer tax if the amount in the retirement account is very large.
6) Not Maximizing Your 401(k) Contributions
Amounts you contribute to your employer's 401(k) plan not only reduce your taxable income dollar-for-dollar, they also grow tax deferred until you have to withdraw them in your golden years. That's a nice tax shelter. And if your employer matches contributions, such as the first three percent of pay you put in, you are missing out on free money if you don't participate. If you choose a Roth 401(k), max out on contributions, too, if you can afford it. Although you don't get an upfront tax break for your contributions with the Roth version, payouts in retirement based on your contributions and earnings on them can be tax free.
7) Missing Quarterly Estimated Tax Payments
Some taxpayers who have the ability to pay their estimated taxes quarterly either don't find the time to do so or prefer to wait to pay their taxes until they file their income tax returns. This is a mistake: you'll pay an estimated tax underpayment penalty to the tune of about eight percent per year for each quarter that the taxes aren't paid.
8) Not Planning Correctly for Exercising and Selling Stock Options
Many employees who exercise options and sell the stock in same-day transactions find that the gains they realize from such a sale push them into a higher tax bracket. If this happens to you, and if your employer simply withholds taxes at a fixed rate from the transaction, be sure to determine just what your actual income tax liability will be so that you're not surprised at the amount of tax you owe come April 15.
9) Not Adjusting Withholding When You Change Jobs
Switching to a new job is a perfect time to review your overall withholding, particularly if you are getting a significant raise. After you have considered adjusting your federal income tax withholding, don't forget about reviewing your state withholding allowances. That will avoid any unpleasant surprises at filing time.
10) Contributing to a Roth IRA When Your Income Is Too High
Individuals whose modified adjusted gross income is over $114,000 ($166,000 for married couples filing a joint tax return) may not contribute to a Roth IRA; doing so will subject you to a six percent penalty on the amount you contributed.
11) Making an Estimated Tax Payment Right After a Big Income Event
Why is this a mistake? If you're otherwise protected from the underpayment penalties (because, perhaps, you are paying through withholding an amount equal to last year's tax or, for higher income taxpayers, 110% of last year's tax), there's really no reason to pay your federal taxes early. Let that money earn interest for you until it's time to pay taxes.
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