Costly Tax Return Mistakes

Tax Settlement Day (April 15) is now less than two weeks away. It’s always a good feeling for all of us when that day comes and passes.

I recognize that I’m a little different, but one of the tasks I actually enjoy is reviewing your tax returns each year.

A tax return tells me so much about your financial affairs, and it provides a terrific opportunity to save money not just now, but for many years in the future.

Over the last two months, I’ve poured through tax returns for many of you while updating your Retirement Blueprint™. In doing so, I discovered a few costly oversights and missed opportunities which I’d like to share with all of you.

But, before I do that, there are two important philosophical points I’d like you to keep in mind at all times with regard to taxes:

  • First, you have every right to pay the least amount of taxes that you are legally obligated to pay. The government has created this enormously confusing tax code. It’s our job to navigate our way through it and make sure they’re not getting any more of your money than they should under the tax code they’ve created.
  • Second, it’s your money, not the government’s money. You created the value to earn it. You saved it. And, you deserve to derive all of the benefits from having done both successfully.

With what you can potentially save by being active with your tax planning, you can take more vacations, go out to dinner more often, give more to your grandchildren, or make a donation to a charity that you really care about.

It simply puts more control in your hands over where your hard earned money goes. And, that’s the way it should be.

Okay, with that said, let’s get down to business.

You may very well want to grab your 2012 tax return while you read this because I’m going to reference 3 specific sections of your return.

Mistake #1: Capital Loss Carry Forward

The first mistake I witnessed more than once was not properly documenting and carrying forward capital losses.

As a refresher, if you purchase an investment for $50,000 and later sell it for $40,000, you’ve incurred a realized $10,000 capital loss.

During the year in which you declare that loss, you can use all $10,000 in capital losses to offset the taxes due on $10,000 worth of capital gains you may have.

If you don’t have $10,000 in realized capital gains to use them against this year, then you can offset $3,000 of ordinary income, and carry forward the remaining $7,000 in losses to use in future years.

While painful when they occur, those capital losses are extremely valuable in future years. You have an opportunity to recover some of your losses in tax savings.

However, if you don’t properly document prior losses, you will not be prompted in future years to use them.

This was the case for a new Relaxing Retirement member this past year. Upon reviewing their last 3 tax returns when developing their Retirement Blueprint™, I noticed that they used to use an accountant to prepare their return, but did it themselves using Turbo Tax for their 2012 return.

When I reviewed their 2010 tax return, I noticed that they incurred a capital loss of over $44,000. They were only able to offset about $10,000 of capital gains that year and $3,000 of ordinary income, so they carried forward $31,000 of capital losses to 2011.

In 2011, they used another $4,000 of losses to offset realized capital gains and $3,000 of ordinary income in 2011, leaving them with $24,000 of capital losses to carry forward to use in future years.

When I took a look at their 2012 return, which they prepared themselves, I discovered that they didn’t carry forward this $24,000 in capital losses.

Even if they’re only in the 25% marginal tax bracket, that mistake could have denied them the ability to recover $6,000 in taxes in future years if they used it to offset ordinary income!

If you’ve incurred capital losses in the past, here’s where to verify them on your tax return:

  • Go to Schedule D (1041)
  • On Part II, go to Line 14. If there is no entry, and you know that you’ve carried forward a capital loss in the past, or you incurred one this past year, make sure that you enter that amount correctly so you can use it in the future. (Otherwise, you forgo the opportunity to use the capital losses to reduce your taxes in the future.)

Mistake #2: Unused Tax Credits and Unused Credits Not Carried Forward

The second mistake I witnessed is one that I continue to see each year on more than one occasion: not using tax credits that they were entitled to either through credits generated this year, or by not carrying unused credits forward from prior tax returns.

For starters, a tax credit is a direct dollar for dollar savings in taxes, as opposed to a tax deduction which lowers your taxable income.

For example, if you had a $10,000 tax deduction, the average taxpayer saves about $3,000 in federal and state taxes (depending on your marginal tax bracket).

However, if you had a $10,000 tax credit, you save $10,000 in taxes. So, they’re extremely valuable.

The mistake I witnessed was the accountant not properly entering the tax credits that they were entitled to.

If you’re entitled to tax credits, here’s how you can spot a mistake:

  • Go to Line 54 on your 1040. If you know you’re entitled to use tax credits and this line is blank, go to Line 45: Alternative Minimum Tax
  • If Line 45 has an entry, this means that you’re subject to the Alternative Minimum Tax (AMT).
  • If you are subject to AMT, then you can’t use your tax credits this year. However, you can carry them forward to use in future years, so they’re not wasted.
  • If Line 45 does NOT have an entry, then a mistake has more than likely been made.
  • If Line 45 does not have an entry, and you know you’re entitled to use credits, then Line 54 should have an entry. If it doesn’t, have your accountant verify the entries he/she made.

In the situations I found this year alone, over $27,800 of tax credits were not properly documented or carried forward, and thus not being used. It was a good day for the Relaxing Retirement members affected when we pointed this out to them.

Mistake #3: Negative Income

The third mistake actually has more to do with a lack of tax planning than an actual mistake on the tax return itself. And, this has to do with NOT withdrawing funds from your IRA when you could have done so without paying any tax at all.

This has to do with a concept known as ‘negative income.

Negative income is a tax term used to explain when a person has no taxable income in the eyes of the IRS. Now, this may sound like a good idea, but it’s not.

Let’s say for example that in 2013 you and your spouse had social security income, a small pension, and interest and dividends from your investments as your income.

Chances are great that if you claimed your personal exemptions and standard deductions, you may very well end up with little or no taxable income.

If you itemize your deductions and/or you have tax credits, it’s highly likely that you have “negative” taxable income. (see Lines 40 and then 55 on your 1040)

If this is true, then you could have had more taxable income and still paid no federal income tax.

The place to “create” more taxable income is by withdrawing more money from your IRA.

In 2013, we had several Relaxing Retirement members withdraw funds from their IRAs, even though they weren’t required to, and still pay no federal income taxes.

Think about that for a moment: withdrawing money from a taxable account and still paying no income taxes. Sounds like a good strategy to me!

What these three examples come down to is the need to have fresh and critical eyes reviewing your tax return. Otherwise, you could unknowingly be making costly mistakes.

Even more important is that tax planning doesn’t take place in March or April! In order to give yourself a shot at legally keeping more of what is yours, you must give significant thought to the tax considerations of everything you do or don’t do.

You could be needlessly giving your money away and not even know it.

If you’re not confident reviewing your return, please let me know immediately and we’d be happy to do it for you.

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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