3 Tax Prep Mistakes Even Smart People Make
The most common tax mistakes are pretty dumb ones, like forgetting to sign the return, garbling a bank account number, or using a nickname instead of the name on a Social Security card.
Even tasks that require some wattage, such as applying common deductions and credits, are not that tough for taxpayers filing electronically, since the software checks for these errors.
Still, there are several mistakes that careful people—even those who hire tax preparers—can make.
1. Minimizing earned income
Business owners have a number of ways to pay themselves and reduce the income subject to Social Security and Medicare taxes. But doing so could put a significant dent in future Social Security benefits, sometimes far outweighing any savings.
One common strategy is to convert a business to an S corporation, which allows the owners to pay themselves a lower salary and then take dividends, which are not subject to Social Security taxes.
That might not cause problems for someone who already has a lifetime of high income, since Social Security bases benefits on the worker's 35 highest-earning years, says financial planner Michael Kitces, a partner with Pinnacle Advisory Group in Columbia, Maryland. For others, though, the impact can be significant.
For example, Kitces says, someone paying 12.4% Social Security tax on $60,000 in earnings would increase the lifetime payout by $128.58 a month.
On the other hand, he says, avoiding $7,440 in Social Security taxes on that annual pay would cost $1,542.96 a month for life in Social Security payouts. Higher earners might suffer less but still could lose more in guaranteed, inflation-adjusted retirement benefits than they save in taxes.
Advisers should calculate the potential impact on Social Security benefits before recommending strategies to avoid the taxes, says Kitces, who blogs at Nerd's Eye View.
2. Choosing the wrong tax preparer
The more complicated a tax return, the more likely it is to drift into gray areas of the law. Ideally, client and tax preparer will be temperamentally compatible when judgment calls need to be made.
A tax pro who is eager to push the envelope may be a bad fit for a conservative client. Likewise, a client who wants to be aggressive about reducing taxes is likely to be frustrated with a preparer who forgoes legitimate deductions for fear of triggering an audit.
"It's more common that the taxpayer wants to push things," says Phil Holthouse, managing partner of Holthouse Carlin & Van Trigt in Los Angeles. "But there are some tax preparers who want to be heroes and give them an answer that's too good to be true."
Holthouse recommends asking tax preparers straight out how aggressive they are. Ideally, he says, the professional will make it clear that he or she stays within the law, but is willing to explain the alternatives in a given situation and help clients evaluate the risk.
When a gray area comes up or if a client is confused about an issue, he or she should ask what rules apply.
"You can tell a lot by how definitive their answer is," Holthouse says. "If they say, 'Nobody's going to see this' or 'Nobody's going to find it,' that's a real red flag."
3. Refusing to delegate
Most people, including some who file the easiest forms (1040EZ and 1040A), hire tax preparers these days. But some with more complicated returns still insist on doing it themselves. Even when they do not make mistakes, they may be investing more time than the task is worth.
The cost for preparing 1040 with Schedule A itemized deductions averaged $261 last year, according to the National Society of Accountants. The IRS says just preparing a typical 1040 takes four hours, with another hour to file it.
That does not even take into account an additional 17 hours for record keeping and tax planning.
Not all of those hours would disappear when using a professional, of course, but the time and hassle would certainly be less.