Don’t pay taxes on these types of protected income. Here are the categories to watch, including 5 types of raises that won’t add a cent to your taxable income.
With the new year in full swing, you’ve probably begun piecing together your tax return. Maybe you haven’t filled out a tax form yet, but you should at least have begun considering your strategies. Before you leap at some new tax-saving tip or take a daring shortcut, though, consider these tales of IRS ire.
We recently asked our readers and Facebook fans to tell us their biggest tax blunders; their responses ranged from the comical to the cringe-inducing. One reader confessed that she once bounced her check to the IRS. Another reader paid $25,000 in fines for listening to the advice of a tax preparer.
Their pain can be your gain. Here are eight tax goofs your fellow readers have made, and tips for how you can avoid following in their missteps:
1. Was your debt forgiven? Report it as income.
In our sputtering economy, Americans are renegotiating credit card debt as never before. Yet many don’t discover until later — sometimes much later — that in the view of the IRS, canceled debt from credit cards is income. “What we didn’t know was that all the savings were considered income,” one reader told us. “We were charged late charges and penalties.”
Taxes: Fixing mistakes
Credit card companies report forgiven debt to the IRS on Form 1099-C (.pdf file). “You should receive a copy,” says Tracy Coenen, a forensic accountant whose practice, Sequence, assists taxpayers with tax audits and tax fraud investigations.
Things get more complicated with mortgage debt, and you may want to talk with a tax expert if you have restructured your home loan. Coenen notes that canceled mortgage debt on your primary residence may be eligible for exclusion from income under the Mortgage Forgiveness Debt Relief Act, which applies to debt forgiven starting in 2007. The law remains in effect through 2012.
2. Report all your jobs.
Several readers admitted that they’ve forgotten to include some sources of income. One woman said she neglected to include her husband’s $27,000-a-year job in 2008, and still owes a fine of $3,400. “I think this is just about as stupid as one can get!” she wrote. Another forgot about two weeks of work her husband put in for one company. Even though they filed for the correct amount once they got the W-2 Form, she wrote, “HUGE problem!”
3. A tax break for what? Don’t get scammed.
If it sounds too good to be true, it probably is. One reader told of following up on a radio pitch that offered a tax credit for creating a website accessible to the blind. The company, also a tax preparer, set up a website for the reader — for a fee. He said the cost of setting up the site was about equal to the tax break. Then three years later, he got a “fat envelope” from the IRS telling him he had to prove he had a legitimate website or pay the IRS $2,000. “I wrote them a check the next day.”
4. Handle your Roth IRA with care.
Looking forward to tax-free income when you retire? That’s the promise of a Roth IRA. Individuals who qualify can set aside after-tax income in the investment accounts, then withdraw the money (plus any investment gains) tax-free at retirement.
But such tax benefits don’t come without restrictions — including income limits on who can set up a Roth IRA. There are also complicated rules for how to convert a traditional IRA into a Roth IRA.
Such accounts have tripped up several of our readers. One said she improperly housed a Roth account inside an insurance vehicle. When she transferred the money out of the account, she had to pay a 10% penalty and count earnings as ordinary (taxable) income.
Another reader bemoans that he did not convert his traditional IRA into a Roth in a year when his income was particularly low.
5. Don’t let ‘I do’ undo you.
One woman told us that in the first year she was married, both she and her husband sent in tax returns, and both checked the “married filing jointly” status. They realized their mistake when the IRS sent them two refund checks. “It took nine months of writing and calling the IRS” to straighten things out, she recalled. “I still chuckle.”
Another reader wrote that his wife claimed her son as a dependent the year after he got married. The rules for when you can claim adult children as dependents are complex, but marriage typically rules out the dependent tax break. “We ended up repaying the refund we got, as well as penalties,” the reader writes.
Coenen says that a married, adult child can sometimes be claimed as a dependent on a parent’s tax return if certain provisions are met. But the child can’t also file a joint tax return with his or her spouse. “It is likely that the son in this case filed a tax return with his spouse, so the dependent exemption his parents attempted to take was later denied,” Coenen says.
For deductions you more likely can take, read “10 big deductions too many of us miss.”
6. Was your student loan debt paid by your employer? Make sure the IRS knows.
If you’re lucky enough to have your employer cover some of your student loan debt, don’t forget the tax man. In the eyes of the IRS, it is pay and must be reported as income on your W-2. One reader, who assumed her employer had taken care of the arrangements, wrote on our Facebook page, “The Army gave me money towards a student loan and didn’t hold back any taxes, I assumed they had, so now I’m paying the IRS back! Oops.”
7. Don’t be afraid to second-guess your tax preparer.
If your tax preparer’s advice contradicts your past experience, get a second opinion from another preparer — or, better yet, from the IRS. One reader spared us the details, but summarized her biggest tax mistake: “I listened to my tax preparer.” About $25,000 in fines later, the reader said, “I should have checked with the IRS.”
Another reader, who owns rental properties, missed out on deducting mileage for visiting the properties, as well as the cost of tools he used for repairs. He said he had his doubts, but he was in a rush, so he stuck with the advice of his tax preparer. He later confirmed that the deductions likely would have been allowed by the IRS.
8. If your taxes get complicated, consult a tax preparer.
This may sound like it contradicts tip No. 7. But many readers who told us about their dumb mistake said they regretted that they hadn’t hired a tax professional. One reader messed up the paperwork for requesting a refund after moving to a new state. The mistake triggered an audit. (See “6 ways to avoid an audit” for more.)
Another reader wrote: “Tax laws are constantly changing and there are deductions out there that you have no way of knowing about.”
Ultimately, you are the one responsible for the accuracy of your income tax return. But a good tax preparer can save you time, money and headaches by fixing often silly and sometimes costly mistakes. Read “Should you do your own taxes?” if you could use help deciding whether to hire a professional — and “Do it right: Your 15-point tax checklist” if you plan to go it alone.
Correction: This article originally incorrectly referred to a change in laws surrounding IRA conversions. During 2010 only, any taxes due on a Roth IRA conversion could be spread over two years.