Last week I wrote about the unexpected $5,600 tax bill that's my 2010 debt burden. I did that to myself but you can avoid my mistake, and the top five mistakes that cost taxpayers each year, according to Michael Ellis, a certified public accountant and the new resident tax expert here on the Money Corner. I asked Mike to give you some tips since tax time is here.
Underpaying your taxes
As an employee:
1.) Underpaying taxes or under withholding taxes. Whether you're self-employed or an employee, your taxes are due throughout the year to the IRS and your own state. The IRS requires that taxes be paid as taxable income is earned, which is why instead of receiving your actual “gross” salary, taxpayers you get your “net", which is the amount you are entitled after state and federal taxes are withheld every pay period.
However, the amount of taxes withheld is determined by you when you fill out the W-4 with your employer. Claim too many allowances and you may underpay your taxes and find that you owe a significant amount more -- including penalties and interest for underpaying your taxes. The easiest way to fix this pitfall is to pay close attention to your W-4 when you fill it out and reassess your allowances every year to account for changes in your tax situation.
As a self employed taxpayer:
2.) If you're self-employed, you are responsible for making your own tax payments. The simplest way to do this is to make quarterly estimated tax payments to the IRS and state. Estimate your tax liability for the year based on either previous year's earnings or current year known taxable income and write quarterly checks to US Treasury and your state's revenue department. This is done with a voucher issued by IRS (1040-ES) and most state tax agencies. You may also make your payments online.
Failure to make these deposits usually results in substantial underpayment of taxes and subsequent penalties and interest. You will find yourself in a constant uphill battle to bring your tax payments up to date as you will probably still be earning taxable income as you try to catch up. The key to avoiding this issue is withholding at least 25% of every self employed check your receive in a separate account to use for paying your taxes. In some situations you may need to withhold up to 40% of your self employed income depending on your deductions and amount of income.
As a self-employed taxpayer:
3.) When self-employed, you are responsible for keeping your own records and receipts for business deductions that directly and indirectly relate to your business activity. Keep three things in mind when trying to determine what's deductible: Is the expense “ordinary” and “necessary” for your business to operate and is the expense “reasonable” in amount?
Use this criteria to be sure your expenses are deductible and you will substantially reduce your tax liability.
An easy way to avoid this problem is to always have a separate bank account for business activity that you use exclusively for business transactions. This way you will have a 12-month record of all income and expenses. Lastly, be sure to keep receipts for your business transactions and stay organized! Once the receipts get out of control, the likelihood of missed deductions increases.
4.) Tax credits are available for a variety of common expenses and situations that go unnoticed every year. Depending on your tax preparation method (tax preparer, CPA, boxed software, etc.) you may need to do a little research yourself to see what’s available.
The best way to do this is to simply Google “2009 tax credits” and you will find an abundance of tax credit-related articles that may help you plan and keep records for eligible spending like education, energy efficient property expenses, child tax credits or retirement savings credits.
Finally, if you use a qualified tax preparer, you may be able to plan for refundable credits such as the earned income credit and first time homebuyer credit by analyzing taxable income and delaying or accelerating income to help force you into eligibility. This is a tool best offered by tax professionals that may save you thousands of dollars.
5.) The way you receive your refund may also save you money. Over the past 5 years, Refund Anticipation Loans, or RALs, have become very popular among eager taxpayers. These loans (usually issued by affiliated banks) will immediately issue your refund to you instead of waiting for the refund to be issued from the IRS or state.
But BE CAREFUL! The cost of these loans can vary widely but expect to pay between 3 percent and 5 percent interest for the benefit of a very short term loan. If you file your taxes electronically, your return could get to you in as little as a week. Meanwhile, the cost of a refund anticipation loan could be equivalent to a 97% to 2000% APR depending on the size of the refund and the actual refund dispersing date. In short, it's not worth it.