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Don't make these tax mistakes

  • By Laura Saunders,
  • The Wall Street Journal
  • – 01/31/2014
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How should you feel about this year's taxes? It's complicated.

The Internal Revenue Service opened its filing season Friday, and by midnight on April 15 the agency expects to hear from individual taxpayers filing nearly 150 million returns for 2013.

Thanks to the growing complexity of the tax code, that is 150 million opportunities for U.S. taxpayers to shortchange either themselves or Uncle Sam by making multiple errors.

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For 2013, taxpayers will have to deal with a new tax on investment income, a new limit on deductions and a new phaseout of exemptions, among other provisions.

"Tax complexity confounds taxpayers and even preparers, and it's a major source of errors," says Nina Olson, the national taxpayer advocate, whose role is to be the taxpayers' voice before both Congress and the IRS. "Every year there's talk of simplifying the code, yet every year complexity seems to increase."

Consider: Last year's "fiscal cliff" revisions brought the total number of tax changes since 2001 to 4,838, or more than one a day, says Mark Luscombe, principal analyst at tax publisher CCH, a division of Wolters Kluwer.

All that complexity exacts a steep price. According to Ms. Olson's latest data, individuals and businesses spend more than six billion hours a year complying with income-tax filing requirements. In 2010 that came to about $168 billion, or 15% of total revenue collected.

For individuals, filing season often means choosing among options that are costly in time, money or both.

More than 50 million taxpayers prepare their own returns and run the risk of paying the IRS too much or too little. H&R Block is basing its tax-season marketing blitz this year on research it says shows that one in five self-preparers forgo an average of $460 each due to such mistakes.

Errors of underpayment bring woes as well. Even innocent ones, such as a transposed number, can cause months or even years of wrangling with computer-generated letters imposing penalties or threatening liens or other drastic actions.

"There's no way to email the IRS, and often you can't get them on the phone, either," says Doug Stives, a professor of accounting at Monmouth University in New Jersey.

According to Ms. Olson, taxpayers turn to paid preparers for help with nearly 60% of returns. But that is expensive, and professionals can make mistakes as well—especially if clients fail to share important information.

"Preparers aren't clairvoyant, and they don't know what you don't tell them," says Laura Peebles, a tax specialist at Deloitte Tax in Washington.

No matter how you tackle your taxes, here are errors to watch out for.

Claiming the wrong number of dependents

Each dependent exemption is worth $3,900 for 2013, although some higher earners will lose part or all of these breaks this year, due to the alternative minimum tax or a new "phaseout" provision that limits the exemption.

In general, someone is a dependent if you provide more than half his or her support — even if that person doesn't live with you or isn't a relative. IRS Publication 17 (available on IRS.gov) has 11 pages of details, including a 26-line work sheet.

Experts say that taxpayers often make errors with relatives who are undergoing life transitions. If your child finished college and got a job last year, for example, he still may be your dependent if you paid tuition and other expenses totaling more than half his support.

There is little chance of double-dipping with this break, however: Most returns are filed electronically now, and the IRS's computers automatically reject any that claim a dependent already claimed on another return.

Failing to itemize deductions

Don't be too quick to take the standard deduction of $12,200 for joint filers ($6,100 for singles) and forgo itemizing your deductions on Schedule A — even if you don't have a mortgage with interest to deduct. You still could trim your tax bill.

Jackie Perlman, a specialist at H&R Block's Tax Institute, says failing to itemize is a frequent mistake. "State income taxes, plus personal property tax on a car and a donation or two, can make itemizing worthwhile," she says. She adds that for people in states without an income tax, the deduction for state sales taxes still applied in 2013 — and that could be another reason to itemize

Overstating charitable gifts

The IRS provides an overview of what you can deduct, and to what types of groups, in Section 24 of Publication 17. Experts say mistakes involving charitable donations are extremely common.

In general, donors have to subtract the value of any goods or services they receive from the deduction. So if you pay $100 to go a fundraising dinner, and the dinner was worth $40, you can deduct only $60.

Taxpayers must have a letter from the charity before filing a tax return for gifts of $250 or more. It must say whether anything of value was received — and if so, how much.

"If you have to, follow up with the charity to get a proper letter," says Annette Nellen, a professor of accounting at San Jose State University in California.

Gifts of property of more than $5,000 (other than traded securities) also require you to have a qualified appraisal before filing the return. In 2012, one taxpayer lost an $18.5 million charitable deduction in U.S. Tax Court because he didn't have the proper appraisal.

Forgetting to claim charitable gifts made through payroll deductions or with IRA assets

The amount of any payroll deduction for gifts to charity won't show up on your annual W-2 income report, Deloitte's Ms. Peebles says.

In addition, IRA custodians often don't remind account owners 70½ and older of donations they have made with IRA assets up to $100,000, a tax-favored move allowed by the law. Although the charity itself should send a letter, this donation still can be easy to miss.

Reporting incorrect net-investment-income tax

The new 3.8% tax on net investment income took effect in 2013 for joint filers with more than $250,000 of adjusted gross income ($200,000 for singles). Congress passed it in 2010 to help fund the health-care overhaul.

The tax applies to net income from rents, royalties, capital gains, interest and dividends, among other things. The IRS issued regulations for the tax in late 2013, but wrinkles remain as software companies update their systems.

If you fail to pay the tax, you may be subject to penalties and interest. Many people with complex returns — especially if they have rental income — will have yet another reason to request an automatic six-month extension to file (but not pay) taxes, says Mr. Stives, the accounting professor.

Overlooking medical expenses

Many people can't deduct medical expenses because of the high hurdles: either 7.5% or 10% of adjusted gross income, depending on the taxpayer's age and whether he owes alternate minimum tax.

But some who qualify for a deduction — many of them elderly — don't take full advantage of it, says Donald Zidik, a tax specialist at Marcum LLP in Needham, Mass.

Deductible costs include not only the uncovered portions of drugs and doctor's bills but also Medicare premiums and some nursing-home or assisted-living expenses. For a full list, see IRS Publication 502.

Mr. Zidik urges taxpayers who can claim a dependent (such as a parent) to remember that they can often deduct eligible medical expenses they pay for that person.

Double-dipping on education or dependent-care benefits

Congress may overhaul the tax code's crazy quilt of education benefits this year. But for now, taxpayers will have to navigate complex rules designed to prevent claiming two tax breaks for the same expenses.

In general, the American Opportunity Credit provides the most benefit for taxpayers who qualify, says Melissa Labant, a tax specialist at the American Institute of CPAs. (For more details, see IRS Publication 17, section 35.)

Similarly, taxpayers aren't allowed to claim a full dependent-care tax credit if they participated in a dependent-care flexible spending account at work in 2013. (See IRS Publication 17, section 32.)

Deducting points on a home refinancing

Because the fees known as "points" are fully deductible for the first mortgage taken out on your primary residence, Ms. Labant says, many people wrongly assume that they can take a full deduction on points paid in a refinancing. They can't.

Instead, the points can only be deducted in equal annual portions over the life of the loan.

Not paying the penalty on an early retirement-plan withdrawal

Most withdrawals from tax-sheltered 401(k) plans or individual retirement accounts before the taxpayer is 59½ incur a 10% penalty and are subject to income taxes. For exceptions, see section 10 of IRS Publication 17.

Note: These taxes and penalties don't apply to qualified account rollovers.

Reporting an erroneous cost basis

A taxpayer determines the taxable gain of an asset he has sold by subtracting the asset's cost (plus adjustments) — the so-called cost basis — from the selling price. So if an investor bought Acme stock at $10 a share and sells at $25, then the cost basis is $10 and the gain is $15.

Experts say cost basis is one of the most error-prone areas of the tax return. For example, taxpayers holding mutual funds in taxable accounts often forget that reinvestments of fund dividends or capital gains raise their cost basis—and lower their taxes. The same holds true for dividend reinvestment plans.

Other cost-basis problems arise when people who sell inherited stock or other investment property don't know its value on the original owner's date of death.

Congress has passed rules requiring brokers, fund firms and others to track basis information for customers, but the rules still are phasing in.

The upshot: Strive to keep good records. Taxpayers selling long-held assets should leave time to gather information. Some companies and brokers can help investors with records, and there are firms that will provide information for a fee.

Ed Mendlowitz, a tax specialist at WithumSmith + Brown in New Brunswick, N.J., says he often allows clients to estimate the cost basis if the total proceeds from a sale come to 10% or less of their overall income. "If it's more than that, you need to do the research," he says.

Not checking income reports for mistakes

To prevent cheating, the IRS now receives a blizzard of reports — such as 1099s — for payments of interest, dividends, capital gains, trust distributions and other income made by third-party payers such as brokerages and banks. It matches these by computer with the information on individual returns, looking for discrepancies.

Tax preparers urge clients to check these forms for mistakes before filing. If there are errors, one strategy is to hold off filing until you receive a corrected 1099.

Another strategy is to enter the reported amount on the return, noting that it is incorrect — and then enter an adjustment so that only the correct one is included in total income.

Overpaying tax on a sale of employer stock

When an employee sells stock options or restricted stock, typically the sale is reported on both the worker's W-2 wage report and a broker's report to the IRS. This can result in your double-counting the taxable income, Mr. Mendlowitz says.

Mishandling the previous year's state tax refund

Even tax refunds can be complicated. Filers who deducted state taxes and received a refund the previous year need to include it as income this year on their federal return.

Taxpayers who didn't get a benefit from their deduction for state taxes the previous year because they owed alternative minimum tax won't owe tax on some or all of the refund.

Not disclosing a foreign account

U.S. officials have been conducting an intense campaign against undeclared offshore accounts ever since Swiss bank UBS admitted in 2009 that it helped U.S. taxpayers hide money abroad.

The penalties for not disclosing a foreign account that you own, control or have signature authority over can be severe — up to half the account, even if little or no tax was owed on it.

There is a box to check on Schedule B disclosing such accounts, and information also may be required on Form 8938. Taxpayers who meet the threshold also must report accounts on a separate Treasury form due June 30.

Not signing the return

As the number of e-filed returns with electronic signatures has grown, this blooper has decreased. But the IRS will always pick it up, a spokesman says.

If you don't sign the return, the agency will notify you and withhold any refund until it hears from you. But if you owe taxes, it will cash your check while it waits.

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