Are You Taking Enough Tax Deductions?
Even when anti-tax sentiment is running high, as it has been in recent times, Americans overwhelmingly accept the principle that filing an honest tax return is a civic duty.
Accountants say their clients often have a higher standard than the IRS requires. Some people will not itemize an expense when they cannot find a receipt, for example, even though not every tax deduction requires one. Estimates that conform to a "reasonable" standard are often adequate although some, like charitable deductions, must conform to a higher one.
Of course people are afraid of an IRS audit. But according to the 2012 Survey of Taxpayer Attitudes from the IRS Oversight Board, 86 percent say it's "personal integrity" that motivates them to be honest, and just 40 percent say they file faithfully out of fear of being caught doing something wrong.
To be sure, U.S. taxpayers don't skimp when it comes to claiming deductions. They list more than $1 trillion a year on tax returns. Still, accountants say they often miss obvious ones. Here are some ways people slip up:
Missing changes in tax laws. The tax code is not chiseled in stone like the Ten Commandments. In some years, there is not much new but in other years, the code can change significantly. The 2013 budget year was expected to bring big changes, but most were incremental. The top rate rises to 39.6 percent from 35 percent for the upper income bracket, which also faces higher dividend tax and a phase-out of tax deductions. Inheritance and gift taxes were added, but at relatively high thresholds. New or increased college tax credits and breaks for energy saving will soften the blow for many middle-income payers. Still, the tax code is as complex as ever.
"In general when people are preparing tax returns themselves, they not equipped to understand all of the changes in the law from year to year," says Gary DuBoff, managing director of accounting and financial planning firm CBIZ MHM.
Job-hunting expenses. With unemployment high, people are busy looking for jobs at all career stages. Even costs associated with an exploratory visit to a potential employer can be a deductible item. It's worth keeping track of all professional visits that might be considered job prospects. The IRS allows 56.5 cents per mile if you drive. But career re-inventors beware: One of the quirks of the tax code is that job searches outside your present line of work cannot be deducted.
Charitable work deduction. People at all ages, from teenage to retired, are doing more volunteering. Most people know to deduct contributions, but "a lot of people don't realize they can deduct expenses for their work," says DuBoff. They shrug it off as "just what I like to do." They can't deduct their time, but they can write off related costs such as transportation and supplies. You don't have to be a soup-kitchen volunteer to qualify. "Volunteering as a soccer coach or a class mom would also be a charitable work," says DuBoff.
Refinance point deduction. In this year's big wave of mortgage refinancing, most loans no longer require payment of points, the upfront interest charges assessed at the start of a home loan. But some people forget to take a deduction on points they still pay for previous mortgages, DuBoff says. When you extinguish your old loan, you repay remaining points all at once. That amount is entirely deductible.
Tax deductions vs credits. Not all tax breaks are alike. Be aware of the difference. A $500 energy tax credit might not seem like much, but it is what is known as an "above the line" item, meaning it lowers the amount of your tax bill on a dollar-for-dollar basis. Tax deductions are figured on your income tax rate. If you are in a 28 percent tax bracket, the tax deduction trims 28 cents from each dollar you deduct.
Childcare deductions and flexible spending plans. People often avoid this one because of the paperwork and hassle of paying "on the books" for a few hours of childcare here and there. But there are allowances that make it worth the effort. The childcare credit, an above-the-line item, reduces taxes by 20 percent to 35 percent of the first $3,000 spent for one child or $6,000 for two, depending on your income level. That credit can be used for parent care, too. The IRS also allows up to $5,000 for workplace flexible spending of pre-tax dollars for nannies, after-school care, and even day camps.
College and education. College costs are usually not deductible, but there are tax credits for tuition and a limited deduction for interest on student loans. Up to $2,500 in interest can be deducted if your income is under $75,000, or $155,000 for a joint return. A college credit of $2,500 for tuition and related expenses is available if your income is $80,000 or $160,000 for joint filers.
Retirement. One overlooked advantage of becoming self-employed, as many are in this era of non-retirement, is that you can use the SEP (Simple Employment Plan) to put 25 percent of your self-employment income up to $50,000 into a tax-advantaged employment plan. People who have had workplace plans often forget to set up their own. "That's a big mistake," says DuBoff. "It's a great chance to put more away."
Tax deductions on taxes. Amid federal budget cuts in recent years, state taxes are picking up a larger share of the tax burden. Those payments are deductible. In states that do not have income taxes, sales taxes can be deducted. Even if you live in a state with an income tax, you might be able to opt to take the deduction for the sales tax paid. The purchase of a boat or a car in some states might generate sales tax that creates a larger deduction than income tax.
Storm expenses. Hurricanes Sandy and Isaac caused billions of dollars of devastation in the eastern United States. Storm damage can be a deductible item if it amounts to 10 percent of adjusted income. If you reside in an official federal disaster area, you can deduct those costs over a two-year period going back two years.
Beyond the fact that it's the right thing to do, being honest is a good guide. But tax codes are sometimes illogical. For example, there are virtually no tax breaks for people attempting career changes, but many for career advancement. So honesty and logic alone will not be enough. When in doubt, consult.
"If you are entitled to a deduction, I firmly believe you should take it," says DuBoff. "Even if you do not have a record of every expense, a reasonable estimate can work. But it can't be frivolous or way out of line." With the IRS increasingly relying on algorithmic filtering of electronic returns, those outliers quickly draw attention.