You want to take advantage of every opportunity to keep your taxes down. But it’s easy to forget the tax impact of many financial decisions. Here are a few of the most common tax mistakes people make and tips on how to avoid them.Because tax rules vary based on income and other factors, you should consult an accountant or financial advisor for advice on your particular situation.
1. Not contributing to your 401(k) or IRA
If your employer offers a 401(k) retirement plan, you should maximize your contributions if you can afford it. Contribution limits vary, but the financial advantages can add up:
- Your contributions are pre-tax. You benefit by having to pay tax on your income only after you’ve made your 401(k) contribution. For example, if you earn $1,000 each paycheck and you contribute five percent, or $50, to your 401(k), you will have to pay tax only on the remaining $950.
- Employers often match contributions.
- You decide how to invest the money from a list of investment options chosen by your employer.
- You don’t have to pay federal taxes on money growing in your 401(k) until you withdraw it at retirement, when you could be in a lower tax bracket than you are now.
If your company doesn’t offer a 401(k) plan, you can open your own Investment Retirement Account (IRA). You can also have both.
2. Cashing in your 401(k) or IRA to pay for a big ticket item
Sure, you may want that money to pay for home renovations or to repay your brother-in-law. But if you take money out of your 401(k) or Individual Retirement Account (IRA), you’ll have to pay tax on it just as though it’s ordinary income and, if you’re under age 59.5, it may be subject to a 10 percent early withdrawal penalty (exceptions apply). You’ll also lose the future growth of that money for your retirement. You’re likely to have far more money in your bank account in the long run if you get the cash you need by taking out a short-term personal loan or low-interest Home Equity Line of Credit (HELOC). The interest payments will probably be far lower than your tax bill. And, in the case of a HELOC, it’s often tax deductible.
3. Paying tax twice on dividends and/or capital gains
Let’s say you spent $1,000 on stocks or mutual funds ten years ago, and sold them last year for $5,000. You’ve made a $4,000 profit. Remember that some of that profit -- let’s say $2,000 -- comes from reinvested dividends or capital gains distributions, which the stock or mutual fund provides you after it has paid your taxes on it. You should owe tax only on the remaining $2,000. Rule of thumb: Uncle Sam only requires payment for your overall profits minus what you made on reinvested dividends and capital gains over the years.
4. Not holding onto investments long enough to earn long-term capital gains taxes
Just a few years ago, the maximum long-term capital gains rate was 20 percent. Now it’s only 10 percent if you’re in the 15 percent income tax bracket and 15 percent if you’re in the 25 percent or higher tax brackets. In order to qualify for this preferential rate, you have to keep certain assets that earn capital gains for at least one year. Otherwise, your gains will be treated as ordinary income, subject to income tax at your marginal tax rate.
5. Forgetting to claim charitable donations
Uncle Sam appreciates generosity. You’re allowed to claim as a deduction any cash, clothing, household items, and donations of old clothing and furniture -- anything you give to a charity in 2004 that has tax-exempt status with the IRS. Plus, you can claim parking fees, tolls and driving expenses to and from volunteer activities for registered charities. Of course, there are limits. Consult a tax advisor to see what you can claim.
6. Not making the most of medical deductions
You can only deduct medical expenses once they reach more than 7.5 percent of your adjusted gross income (your income after certain allowable adjustments such as IRA contributions) within a given taxation year. In other words, if your adjusted gross income was $100,000 in a given tax year, you get a deduction for medical expenses only if they exceeded $7,500 that year. You can’t carry expenses from one year to another, and if you don’t reach the limit in a given year, your medical expenses are not deductible.
To reach that upper limit in a given year, move elective medical procedures or orthodontic work into the same year as other medical expenses, if possible. Be sure to claim all uninsured medical and dental expenses for you, your spouse and your dependents. These can include travel expenses to and from medical treatments, medical insurance payments and uninsured medical expenses such as eyeglasses or hearing aids. You don’t need to send in your receipts, but keep them in case you’re audited.
In addition, some employers provide health plans that include a flexible spending account. These plans allow you to set aside some of your pre-tax salary for qualified healthcare expenses not covered by health insurance, as long as they are IRS-approved medical expenses. These include the deductible you have to pay before your insurance kicks in, non-prescription drugs, contact lenses, chiropractic fees and birth control. You don’t have to pay tax on money in a flexible spending account, but if you don’t use it, you’ll lose it for the year.
7. Neglecting to claim tax credits you are entitled to
Tax credits come right off the money you owe the IRS. In other words, if you owe income tax of $3,000 and have $1,000 in tax credits, you’ll only have to send in $2,000. So make sure your tax return includes the tax credits you are entitled to for retirement savings, education costs, child and dependent care expenses, or earned income tax credits, to name just a few. There’s a worksheet in your tax return instruction book that allows you to calculate the proper credit amount for these expenses.
8. Missing deductions
Many people opt to save time by filing the shortest and simplest income tax form, also known as the 1040EZ, which only requires you to fill in basic income and allowable deductions. This may seem obvious, but some deductions (such as student loan interest or alimony payments) appear only on the two longer personal income tax forms (1040 and 1040A). Depending on your situation, it may make sense to take the time to file using the 1040 or 1040A form.
Please consult an accountant or financial advisor to learn if these general rules apply to you.
Instead of cashing in your 401(k) or IRA to cover an expense: Request a home equity loan or line of credit.
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