Whenever you earn income -- whether as a salaried employee or a small business owner -- the IRS wants its share. This opens the door to multiple tax considerations, and it's easy to make mistakes when you're making such decisions. Such errors can easily lead to a tax audit.
Fortunately, there are answers to all your tax questions. But don't wait until the deadline for taxes looms before seeking tax help. Instead, consult with a tax lawyer or seek another source of tax help. Following are a few of the more common errors taxpayers make, and some tips to help you avoid them.
Forgetting to Review Payroll Withholding Deductions
Getting a tax refund feels good. But if you are a salaried employee or hourly wage earner, it pays to understand why that money is coming back to you.
Over the course of the year, your employer deducts taxes from each of your paychecks and sends that money to the IRS on your behalf. If you get a refund, it means you overpaid. In other words, your estimation of how much you owe is too high.
Employers base payroll deductions on the information you provide when you complete your W-4 form, which lists your dependents and other tax-related information. Trish Maselli, founder and CEO of Clear Cut Accounting Services in Ivoryton, Conn., said employees who don't fill out their W-4 forms correctly might end up overpaying on federal and state taxes throughout the year.
Find Out: How to Fill Out Your W-4
If you overestimate, you'll get a refund. But this means you have effectively used the IRS as a zero-interest savings account for the past 12 months. "My rule of thumb is to have at least 10 percent of your income taken out of your income," said Maselli.
On the other hand, fail to have enough withheld and you'll have to come up with cash at tax time to cover any shortage. You also might owe penalties in some cases. Your withholding should be enough to cover the tax bill at the end of the year.
Review your W-4s regularly. Life changes can occur over the course of the year, and you can adjust your W-4 information at any time.
"Most individuals fail to review this form yearly and really should review it halfway through the year to adjust their withholding deductions so they can adjust their federal and state tax withdrawals," Maselli said.
Overlooking Tax-Friendly Employer Benefits
Paying a portion of employee benefits reduces your overall taxable income in a couple of ways. When you contribute money on a pretax basis, your employer calculates withholding on the balance of your salary. And in many circumstances, your contributions are also deductible on your tax return.
"If you're fortunate enough to work for a company with a comprehensive employee benefits package, this is a great way to pay certain expenses while keeping overall taxable income lower," said Michael Eckstein, a tax accountant with Michael Eckstein Tax Services in Huntington, N.Y.
Benefits that can reduce your income tax burden include transit passes and biking reimbursements. Group insurance is another important benefit. Many employers provide a combination of group health, life and long-term disability insurance. These benefits might require a pretax contribution on your part.
Flexible spending accounts -- or FSAs -- can be used for day care, health services and medicines and prescriptions that aren't covered by your health insurance. The amount of money you can contribute to an FSA is capped at $2,600 in 2017. The balance does not roll over with most FSA accounts -- if you don't use it for qualified expenses, you lose it. So, properly calculate and estimate your financial needs for the year to avoid contributing too much.
Skipping Retirement Account Contributions
Contributing to an employer-sponsored retirement account is among every worker's no-brainer tax deductions.
"One of the biggest tax mistakes made by the average salaried worker is failing to take full advantage of the many valuable retirement tax incentives -- or worse, not participating in the plan at all," said Benjamin L. Grosz, an attorney who works with clients on tax planning at Ivins, Phillips & Barker in Washington, DC.
If your employer offers 401k and 403b retirement plans, you'll get the biggest tax break if you participate to the maximum amount allowed. Contributions are $18,000 per worker in 2017. You can contribute an extra $6,000 in "catch-up" contributions if you're age 50 or older.
If your employer doesn't offer a workplace retirement plan, consider contributing to a traditional or Roth IRA on your own. The maximum contribution limit remains at $5,500 in 2017, or $6,500 for those 50 or older. You can contribute to a Roth IRA or traditional IRA with certain restrictions even if your company offers a pension plan.
Take full advantage of the Retirement Savings Contributions Credit if your salary isn't significant. The IRS calls this the "Saver's Credit," and it allows you to take tax credits for contributing to your IRA or employer-sponsored retirement plan if you qualify. The IRS posts the income limits on its website.
Ignoring Self-Employment Considerations
Many people who are self-employed do not have to deal with employer benefits and W-4 withholding. However, they still have a whole host of other tax issues to consider -- and should learn how to file as a self-employed taxpayer.
The most common mistake self-employed individuals and independent contractors make is not treating what they earn as income, said Scott Goble, a certified public accountant and managing partner of Sound Accounting, based in Chickamauga, Ga.
"When you're self-employed, you are, in fact, operating a small business," he said. "A self-employed individual can deduct many expenses as a small business owner that aren't necessarily available to employed individuals."
Deductible business-related expenses include:
- Home office supplies
- The use of your vehicle for business travel
- Personal computers and software
- Meals and entertainment
- Accounting and legal fees
- Education and professional association dues
You don't claim the totality of your business income on your tax Form 1040 when you run a small business. Instead, you enter it on Schedule C, which allows you to deduct business expenses from that total. But in exchange for this perk, you must pay self-employment taxes.
"Self-employed individuals are subject to a tax equal to 15.3 percent of their net income from business as of 2016," said Goble. They're responsible for paying all Social Security and Medicare taxes -- 12.4 percent for Social Security and 2.9 percent for Medicare. Employers pay half this amount for people who work as employees.
Fortunately, self-employed workers get some of that money back when they file their tax returns. "You get to deduct half that amount as an adjustment to income -- also known as an 'above the line' deduction -- on your Form 1040," said Kay Bell, a tax journalist at the blog Don't Mess With Taxes.
"You must estimate the amount you owe and pay on a quarterly basis," she continued. "If you miscalculate or decide you just can't pay the estimated amount in one quarter, you'll discover that in addition to the taxes due, you'll owe interest on any amount you should have paid -- along with a penalty for underpayment -- when you file your tax return."
Misunderstanding Business Deductions
Many independent contractors who work from home claim expenses associated with their home office as a deduction on Schedule C. This is OK, but the rules are stringent.
"The business space you deduct has to be used strictly for business purposes," said Gail Rosen, a certified public accountant based in Martinsville, N.J.
Such rules mean you can't deduct a second bedroom that doubles as a guest room, said Eric J. Nisall, founder of AccountLancer, which provides accounting help to freelancers. "Your home office must also be your principal place of business. So anyone who spends the majority of his time working from an outside office would be excluded from claiming the deduction," he said.
However, if you meet the requirements, you can deduct a portion of your household expenses equal to the percentage of your home that you use solely for business purposes. It's OK to take a percentage of utility costs, rent, mortgage principal and insurance.
For example, if your home office represents 15 percent of your overall living space, you can deduct 15 percent of these expenses on Schedule C. "But people who try to put all of their household expenses on their return are absolutely overstepping the boundary," said Nisall.
Making Errors That Can Happen to Anyone
Some mistakes cost taxpayers money, but others cost time and create unnecessary stress and headaches. John Adams, a certified public accountant and partner at Cook Martin Poulson in Salt Lake City, listed the following that can cause the IRS to look twice at your return:
- Transposing digits in your Social Security number
- Failing to change your name with the Social Security Administration after you've gotten married or divorced
- Incorrectly claiming dependents
Then there's the problem of simply reporting incorrect numbers.
"It is easier to do than you might think," said Adams. "The difference in tax with a reported income of $89,000 versus $98,000 of income is huge."
He urged you to carefully look over your returns prior to filing to prevent these types of errors. And don't neglect to file a federal tax return or state tax return because you're self-employed and think that income doesn't count.
There's no shame in seeking help at tax time, whether you're a salaried employee or an independent contractor. IRS penalties for some mistakes can be stiff, and you could end up paying taxes you don't legitimately owe.
Your best defense is to enlist the help of a skilled and experienced tax preparer who can help you find ways to legally minimize your tax obligations, or to file an amended tax return if you already have made mistakes.