After the Holiday shopping and New Year celebration are over, there comes the tax collector! For some people, it’s time to pay more money to the government(s). Yet others hope for a nice, much-needed refund. But the truth is, whether you owe Uncle Sam money or get a refund, you may waste money along the process. So filing your tax returns properly will save you big time. Here are my thoughts on saving money with tax return preparation.

The first question you may ask yourself is “Should I go to the tax professional or do it myself?” It’s a tough question, and there’s no good answer to it, because it totally depends on yourself. If you know a bit about tax, accounting, or care enough to read the tax laws and follow instruction, then you should try to file your own tax returns. I do that myself, not that because I know every single tax trick, but because I read  enough about what would apply to my own financial condition. It’s a real challenge, but the rewards are more than just the fees you pay to a tax preparer. Knowledge is power, remember? But, if tax laws sound like Greek to you, or you’re not the type of people  who can follow instruction to the details, then it’s well worth it to pay for the tax professional, or at least a good tax software to walk you through the process.

Whichever the case, you need to understand some important concepts about taxation to prevent yourself from wasting money, or even serious legal troubles. The first basic  concept is Tax Avoidance vs. Tax Evasion. The former is good, as we all try to avoid paying more taxes (on incomes or anything else), while the latter is bad. Tax Evasion means you try to evade the tax law (for example, disobey it, ignore it, or intentionally go against it). It’s not uncommon, people do that all the time. And guess what, it  ain’t save you money! Sure, if you could get away with cheating, then you would get  some money. But believe me, it’s not worth the risk. You may end up paying a lot more in penalties, or even jail time for messing up with the IRS.

So how can you save money with Tax Avoidance? By going through all the categories of deductions and tax credits and see if anything apply to your situation. If anything  applied, you’ll have to claim them, or else you’ll get nothing. It’s extremely unlikely that the government(s) would send you a letter saying something like “Joe, you paid to much taxes and didn’t claim these credits, so we’ll send you this check for the balance owed to you…” That would be nice, but it ain’t gonna happen!

The next concept is about the difference between Deductions and Credits in income tax returns. Deductions mean certain kind of expenses that are subtracted from your incomes BEFORE taxes are calculated. On the other hand, Tax Credits mean “free money” added  to your return AFTER taxes are calculated. Another way to look at it: you save only a fraction of the deductions (depend on your tax bracket), but you get 100% of the tax credits. There are other limitation to deductions as well. For example, both the IRS  and your local governments don’t like to see you list out (itemize) lots of small  expenses for deductions, so they invented the “Standard Deduction” amount, which is a  fixed amount for your situation (filing status). So if the total of all of your allowable deductions doesn’t exceed that fixed amount, you should take the standard amount instead,  thereby saving everyone’s time. In other words, unless you have a lot in deductions,  it’s better to forget about them. In contrast, tax credits are not subject to that kind of limitation. For example, Earned Income Credits are solely based on your income and  conditions such as filing status and dependents.

Next, I’m talking about tax audit. Nobody likes to be audited (by the IRS, or local government). Why? Because even if you have nothing to worry about, it’s a waste of  time. You’re not compensated for the audit process, so why happy about it? Now, contrary to IRS’s claim that they pick returns to audit at random, common sense tells you that  they’re not going to waste their time auditing a “clean” return, thereby missing many other “questionable” ones. By “clean,” I mean the tax returns without questionable deductions,  and with no or little income that is well documented (such as only from W-2’s). Whereas  “questionable” returns would mean those with outrageous deductions or missing support  documents. Besides, auditing is not only about law-enforcing and setting examples, but also about getting more revenues for the government. So by common sense, they should go after bigger fish with higher priority, like those with several hundred thousand dollars annual income, instead of the minimum-wages workers. However, you’ll never know. So the best thing is to prepare yourself. The following are some helpful tips:

1. Minimize red flags in your return. For example, your deductions should be specifically categorized and documented. If you file schedule C (for business), put your expenses in  good categories (instead of something like “Miscellaneous expenses”).
2. Organize your papers, receipts, backup documents so you don’t lose anything and can get access to them more easily
3. If you want to prepare tax yourself, you should use software to help with the process. If you don’t want to spend money for software, there are free ones online (like TaxAct.com). You can always compare your version with software-generated return and change it if you want, that’s the advantage.
4. Like to gamble? Remember that all winnings are taxable income. The IRS allows you to deduct your losses against winning (not against any other income), but if you have no proof for the losses or the money you spent (like putting cash into slot machines), then those deductions become “questionable.”

The US income tax system is pay-as-you-go, meaning that you got to pay taxes WHEN you receive the incomes. The reason is obvious, Uncle Sam is afraid that you can’t pay taxes once the  money is all gone. So it became law, that you must have taxes withheld from your incomes in advance. Many people tend to claim more exemptions with the attempt to have less taxes withheld (from paychecks). They argue that it’s better to put more money in the bank or other investments which earn interest than to keep them at the IRS for later refund. But they forget that it may be against the law to do so. There’re 2 setbacks: first, you may be penalize for violating tax law; second, you may end up paying higher interests than any investment can offer. So it’s not worth it.

Here are the rules I go by:

Rule #1: all incomes are taxable until stated otherwise by the IRS
Rule #2: you can’t invent deductions
Rule #3: read, read, and read

Side note: Some states may refund tax money (in forms of credit) even though you have no income. So file your tax returns!

Disclaimer: this is not a tax or financial advice or anything of that nature. When in doubt, consult with your tax expert.

This entry was posted on Wednesday, January 14th, 2009 at 11:57 am and is filed under Knowledge Power. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.