It’s true that tax filing since the Tax Cuts and Jobs Act of 2017 is less complicated for most people. That’s because the standard deduction was raised, significantly reducing the number of itemized returns. While taxpayers are upset that they don’t get to write off their mortgage interest anymore, tax-preparers are retiring as more people are self-filing. The IRS and Treasury were tasked with additional COVID-19 related duties, such as processing stimulus checks. They are severely underfunded and understaffed.
Generally speaking, tax filing should be easier than ever. Unfortunately, according to the Taxpayer Advocate Service, “Calendar year 2021 was surely the most challenging year taxpayers and tax professionals have ever experienced…” Of course no one wants to be audited, but concerns go beyond that. An incorrectly filed return can result in a delayed or reduced refund. With the IRS and taxpayers facing unprecedented challenges, what misconceptions or pitfalls should you consider as we wrap up this tax season?
You should be excited about a large tax refund.
Right or wrong, some people will always eagerly anticipate their annual tax refund. However, overpaying taxes throughout the year is like giving the government an interest-free loan. The U.S. Treasury will pay you interest if they’re at fault and owe you money, but not if they owe you a refund because you overpaid taxes. So why do people continue to do it?
In many cases, taxpayers don’t know how to fill out their W-4. Even with its redesign in 2020, the new W-4 is still complicated, despite the IRS’s effort to reduce “…the form’s complexity and increase the transparency and accuracy…” Often, taxpayers like refunds as a simple means to save money. They treat their yearly tax refund as a bonus. After all, while the Treasury pays you nothing in interest, the bank will only pay you next to nothing. So what are you really losing? That’s not the point.
An enrolled agent colleague of mine often told his tax clients “Always owe the government.” From his experience, it was so important that he’d be sure to say it twice. “Always owe the government.” Of course, don’t owe too much or the IRS can hit you with an underpayment penalty. But what’s the harm if the government owes you? Not much really, until they get backlogged in processing or decide that they don’t actually owe you that big refund you’ve been anticipating. Firstly, the IRS has been significantly and consistently backlogged since the COVID-19 crisis began two years ago. You might even be waiting on last year’s refund, as the IRS is still sitting on millions of unprocessed returns. They expect that backlog to continue through 2022.
Secondly, the IRS feels they could be missing nearly $1 trillion dollars in annual income tax revenue due to those who underreport their incomes or take too many deductions. We’re seeing extra scrutiny on tax refunds, so you might expect to jump through a few more hoops to get that refund now. If you’ve ever tangled with the IRS, you know those hoops are many. You may find it challenging to resolve issues when they are too backlogged to answer their phone calls, as they have been for much of the last two years. So don’t expect that refund in a timely manner.
Not filing or paying on time, or not filing at all.
Are we really required to file taxes every year? If you’re working full time, you likely must file. If you have federal withholding on your W-2, you should file to determine if you get a refund or owe taxes. If you have 1099 self-employment income, you need to file because you likely owe self-employment taxes. But if your taxable income is less than your standard deduction or your only income is social security, you probably don’t need to file.
Whether you need to file or not, the real question is should you file. Many times it pays to at least prepare a tax return, even if you don’t file it. Maybe you worked part-time while receiving social security. You probably had federal withholding unless you were able to request no withholding on your W-4. Take the time to prepare a return. Maybe you’re due a refund.
Do you have young children? You may get a nice child tax credit and a refund. Are you or a dependent attending post-secondary education? Costs are likely deductible and you may be entitled to education tax credits. Sometimes you may not need to file a federal return, but your state might actually have a refund for you. The takeaway here is that if you have earned income, you likely need to file.
But what if you file late, or pay your tax bill after the deadline? Penalties are incurred, specifically failure to file and/or failure to pay. These penalties can be substantial for those taking no action on a big tax bill. Remember that filing an extension gives you extra time to file, but not extra time to pay. So even if you have a large tax bill and no money to pay it, at least file the return to avoid the failure to file penalty. Many people don’t know that they can actually arrange a payment plan with the IRS, which reduces the failure to pay penalty. No matter how you feel about paying taxes, you’d probably detest paying a penalty on top of that tax bill. When in doubt, prepare a return and file on time, even if you don’t have the cash to pay the bill today.
I must incorporate my small business to get the most deductions
If you run a new small business with little revenue or profit, incorporating will likely not help you on the tax return. After taking on the hassle and expense of incorporating, you may find yourself making required quarterly estimated tax payments, even with a minimal tax bill. Filing as an S-corp or sole proprietor often entitles you to the same deductions as a corporation. Note that incorporated businesses may gain flexibility when looking to deduct for health insurance.
I’ll probably get audited if I take a home office deduction
This might be true if you don’t run your own business, but take the deduction. Tax filers are anxious to take the deduction if their employer allows them to work from home, but this deduction is only permitted for self-employed tax filers. But it is a common deduction nonetheless and it’s not necessarily a red flag.
Unfortunately, because the IRS knows that some companies reimburse employees for work-from-home expenses, they aren’t inclined to offer deductions for costs like internet, phone, and home office supplies. Strangely though, there is no federal requirement for employers to reimburse employees for these expenses. Check your state’s regulations, as there are about 10 states that require reimbursement for such expenses. The bottom line is that W-2 employees do not get to deduct home office expenses, but review your eligibility if you’re self-employed.
I think I’ll take a vacation and call it a business expense
Yes your business trip is deductible, but not your trip to the beach with the kids. Only legitimate business expenses are deductible. Even if you extend your business trip by a night or two for personal reasons, the IRS will frown upon deducting those additional costs. Don’t take the family out and call it a business dinner. Business owners often give themselves too much leeway here and the IRS knows it. While it may not necessarily trigger an audit, I wouldn’t want to explain to the auditor how my four days at Disneyworld with kiddos were a business expense.
That said, actual business expenses should be tracked carefully and thoroughly. Documentation is important in case of audit of course, but also to ensure you’re getting all eligible deductions. Track your miles driven, but don’t include your commute. If your vehicle is strictly for business, track actual expenses and you might even depreciate the vehicle. Track parking fees, tolls, registration fees, and auto loan interest. How and when these business expenses are deducted is complicated, so be sure to work with an experienced tax professional.
My wife and I make almost $200,000 combined, so we pay 24% income tax?
Well that’s what the 2022 tax table says anyway, suggesting a tax bill of $48,000. So what is the marginal tax rate? And what is the effective tax rate? What’s the difference? Despite the tax table, not one dollar of that income is taxed at 24%. How is that?
The married filing jointly standard deduction of $25,900 lowers the combined income under $175,000, dropping you into the 22% tax bracket. Income above $83,550 is taxed at 22%, while income below $83,550 is taxed at 12% or less. Because almost half the remaining income is taxed at 12% or less, we actually pay only about $30,000 in taxes.
Dividing $30,000 by $200,000 gives us only 15%. This is our effective tax rate. Above the line tax deductions and other tax credits could lower the tax rate further, below 15%. It’s not the marginal rate that counts. We care about the effective tax rate and good tax software should display it. It’s important because you have some control over that rate, based on a good tax strategy. Work with an experienced tax professional for a proactive tax plan and keep that effective tax rate down to a minimum.
I don’t have to make quarterly estimated tax payments
Actually, if you can’t withhold federal taxes from each paycheck, you have to make tax payments each quarter. Small-business owners, self-employed individuals, and workers who receive a 1099 instead of a W-2 still have to make quarterly tax payments throughout the year. You’d want to work with your CPA to estimate next year’s tax obligation and divide it by four to get that estimated quarterly amount.
The IRS may not penalize you if your annual tax bill is under $1000. But the requirement exists, and you likely don’t know what your tax bill will be. If your side-hustle is a money maker outside your regular job, you can avoid the estimated payment requirement by withholding an accurate amount of extra taxes from your regular paycheck. You can also avoid the penalty by making sure your estimated tax payments are at least 90% of the total tax obligation, or by paying 100% of the prior year’s obligation. Consult your tax advisor for more information.
Forget the garage sale. I’ll just donate my old stuff for the tax deduction
Not so fast. If you’re like most people, you’ll take the standard deduction and get no tax benefit from your donation of goods. That standard deduction is so large with the Tax Cuts and Jobs Act from 2017 that you likely don’t have enough old stuff to donate. Almost no one itemizes these days. Even if you do, the IRS might question that your old clothes and VHS tapes amount to a donation of several thousand dollars.
However, what many taxpayers don’t know is that cash donations to qualified charities have recently become deductible, even if you take the standard deduction. The CARES Act included a special tax provision for the 2020 tax year, which allowed individual and joint filers to deduct up to $300 on cash donations made to eligible charities. For the 2021 tax year, this provision was expanded to allow up to $300 per individual. That means up to $600 for joint filers. It’s one of the few “above the line” deductions still available. So even though you probably won’t get a tax break for your stuff, you can at least get some tax relief with cash donations if you’re charitably inclined. Don’t forget that your state may offer certain tax deductions and credits, even if the feds don’t.
I don’t need a tax professional or financial planner.
Do any of the topics above apply to you? Then you should consider working with a tax professional. If you don’t have a family or substantial mortgage interest/ charitable contributions, and your income is strictly W-2, you can likely file on your own. For more detailed information on the necessity and benefits of a tax planner, see the recent article posted on our My Financial Coach website.
But what about a financial planner? Charles Schwab Corporation conducted their Modern Wealth Survey last year. Schwab’s survey shows only a third (33 percent) of Americans have a financial plan in writing. What are your financial goals? You can’t achieve a goal you haven’t yet set. How are you progressing toward your goals? A financial plan will be your gauge.
The misconceptions and pitfalls I’ve described impact you far beyond your annual tax bill. What should you do with that unexpected tax refund? A financial planner can discuss the best use of that windfall. Are you putting off tax filing because you don’t have the money to pay a big tax bill? A good planner can help you budget and explore options to make room in your cash flow to set aside taxes in advance. Are you making the best choices for maximizing your retirement savings and tax deferral? Strategies and options are complicated, but choosing the right savings vehicle can have a significant impact on your future and goals.
Working with a CERTIFIED FINANCIAL PLANNER™ at My Financial Coach will help you assess your needs and define your financial goals. A plan is your roadmap to achieving your goals and your planner is there to make sure you stay on track.
Jonathan Vander Werff, CFP®