Annually, taxpayers end up paying more taxes that they really needed to pay - either because of faulty planning, or by not taking advantage of all the deductions that are available. Here are some of the more common errors to keep in mind.
Not Planning for the Alternative Minimum Tax (AMT)
The alternative minimum tax (AMT for short) surprises a significant number of taxpayers each year. Basically, the law requires taxpayers whose taxable incomes exceed a certain level to recompute their taxable income by eliminating certain "tax preference items." These preferences include state taxes, car license fees, real estate taxes, certain home equity interest paid, a portion of your medical expenses, and most miscellaneous itemized deductions (such as income tax preparation fees and employee business expenses). Your tax professional can help you better understand how this law applies to your personal situation.
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 taxes will get you any tax benefit.
Not Using a Computer to Plan for & Prepare Your Income Taxes
There are so many interrelationships in the tax law that even if you have a simple income tax return, you can miss something important by doing your income tax return or tax planning by hand. At a minimum, use a personal tax program (like Turbo Tax) if you have a relatively simple return. However, if you have a business, rentals or a significant amount of investments, you would be better advised to use a professional. Often, the tax your save (or problems you will avoid) will more than offset the cost of tax advice or return preparation.
Overusing a Home Equity Loan
It can be a good idea to convert otherwise non-deductible personal interest into tax-deductible home loan interest. But don't get carried away and take 15 years to pay off a three-year car loan or you'll pay a fortune in interest. Also, be aware that just because the loan is secured by your home, there are limitations on how much of your equity loan is deductible. Generally, you can deduct interest on an equity loan up to $100,000 when used for any purpose (vacation, car, etc.). However, such interest is NOT deductible for AMT purposes - meaning, you may not get a tax benefit for the interest paid. Generally, home equity loan interest incurred on a loan to build or improve a residence is deductible for both regular and AMT tax computations.
Taking the Home Office Deduction Without Considering the Tax Effects When You Sell Your Home
The part of your home that is used for business may not qualify for the (maximum) $250,000 ($500,000 if Married Filing Joint) exclusion of gain from tax on the sale of your home; you could end up paying taxes on the home office portion of the gain.
Not Claiming all of the Deductions You are Legally Entitled to
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. Be sure to take pictures of the items you donate, have a detailed description of the items (and their condition), and a receipt from the organization to whom you donate the items. There are appraisal requirements for any individual items over certain dollar amounts. Be sure to read about those requirements.
Not Accounting for Mutual Fund Dividend Reinvestments
Reinvested dividends generate tax basis. Be sure to add them to your cost basis when you calculate your taxable gain from the sale. It is best to update your records annually. For example, you pay $1000 for a particular stock in 2000. In each of the years 2001 through 2005, you received $50 in dividends that you reinvested in the same stock. Each year (2001 through 2005), you add $50 to your income (dividends received) and pay tax on that amount. If you sell the stock in 2006, your basis will be $1250 (your original $1,000 investment plus the reinvested dividends of $50 for each of the five years). Remember, keep detailed records of your dividend reinvestments!
Not Tracking Your Year-to-Year Carryover Items
State and local taxes paid for the prior year in the current year, capital loss carryovers from prior years, and charitable contribution carryovers can get lost in the shuffle.
Not Setting up a Qualified Retirement Plan in Time
Most qualified plans must be established (but not necessarily funded) by December 31 of the tax year in which you want to take the deduction. Many IRAs can be set up through April 15 of the following year, and SEP plans can be set up as late as October 15 of the following year.
Failing to Name (or Naming the Wrong) Beneficiary to an IRA, 401(K), or Other Retirement Plan
Upon your death, IRA accounts pass tax-free to your spouse. If you designate no beneficiary for your retirement accounts, many plans name your estate as the beneficiary, which can be the most costly to your estate. Naming grandkids may subject the account to the generation-skipping transfer tax (that is not good either....).
Not Maximizing Your 401(k) Contributions, Particularly if Your Employer's Plan Provides for Matching Contributions
Current tax law provides annual increases in the maximum amount contributable; be sure to take this into consideration when planning for your financial future.
Not Making Your Quarterly Estimated Tax Payments When You're Self-employed or Have Significant Investment Income
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 when they file their income tax returns. This is a mistake: you'll pay underpayment penalties to the tune of about five percent per annum for each quarter that the taxes aren't paid.
Not Planning Correctly for Stock Option Exercise & Selling Activities
Many employees who exercise options and sell stock in same-day transactions find that the gains they realize from such a sale push them into a higher tax bracket than they'd otherwise be in. If this happens to you, and if your employer simply withholds taxes at a fixed rate from your sale 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 17.
Changing Jobs and not Adjusting Your Withholding Allowances
Be sure to consider your state income tax withholding allowances once you've adjusted your federal numbers. Your federal withholding may be just fine, but forgetting to adjust your state withholding as well may set you up for an unpleasant surprise. So, check to see if you need to update your Form W-4. The same advice is true if during the year your spouse begins working (meaning, you will need to consider his or her income along with yours in estimating your annual liability).
Contributing to a Roth IRA When You're not Qualified to do so Because Your Income is too High
Individuals whose modified adjusted gross income is over $110,000 ($160,000 for married couples filing a joint income tax return) may not contribute to a Roth IRA; doing so will subject you to a six percent penalty assessed on the amount you contributed.
Making a Federal Estimated Tax Payment Right After a Big Income Event Rather than Waiting Until April 17
Why is this a mistake? If you're otherwise protected from the application of underpayment penalties (because, perhaps, you are paying through withholding and estimates 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 Uncle Sam.
Withdrawing from an IRA Account for Tuition
A recent Tax Court decision (Ladder-Beckert, TC Memo 2005-162) makes it clear that taxpayers who withdraw funds from their IRA account to pay tuition expenses for themselves or their dependent child(ren) MUST pay the tuition in the same tax year as they make the withdrawal. Otherwise, they will not qualify for the penalty-free early withdrawal. As a side note, the same interpretation would likely apply to other early withdrawals used to pay qualified medical expenses or first-time homebuyer expenses. If the payments are not made in the same year of the withdrawal, then the early-withdrawal penalty will likely apply.