Saturday, October 8, 2016

5 Federal Income Tax Rules to Live By

FROM FOOL.COM

Let's face it, most Americans absolutely dread Tax Day, and it's not hard to understand why. According to a Pew Research poll conducted last year, 72% of Americans surveyed felt bothered either "a lot" or "some" by the complexity of the U.S. tax code.

What was at one time a 1.4 million-word tax code in 1955 has ballooned into more than 10 million words, complete with 2.4 million words of federal internal revenue code and nearly 7.7 million words of federal tax regulations as of today. The Tax Foundation observed that this has worked out to be the addition of 144,500 words to the U.S. tax code every year since 1955.

Yet following some very simple federal income tax rules could make your life a lot easier come tax time. Here are five federal income tax rules you should live by.


1. Never do your taxes by hand
One of the smartest moves you can make is to put the pencil down and instead prepare your taxes using tax software or a tax preparation service/accountant. Tax preparation software takes a lot of the guessing out of preparing your taxes, and it handles the grunt work of adding and subtracting that could lead to a critical error on your taxes. Another ancillary benefit is that e-filed tax returns done via tax software are legible, which may not always be the case for tax returns mailed in and prepared by hand.

According to the Internal Revenue Service, the error rate for e-filed tax returns was just 0.5% in 2013. Comparatively, 21% of paper returns were found to have an error. This 41-fold increase in error rates just isn't worth the risk. Thankfully, 91% of the total returns filed by taxpayers in 2015 were e-filed, but this still leaves somewhere in the neighborhood of 13 million tax filers who could be playing with fire.



2. Aim for $0
It's no secret that Americans are generally poor savers. Based on July 2016 data from the St. Louis Federal Reserve, the personal household savings rate stood at 5.7%, half of what it was 50 years ago, and well below the personal savings rate of households in most developed countries. This is why approximately 80% of tax filers are often thrilled to receive a refund from the IRS in any given year.

However, getting a refund from the IRS isn't necessarily great news. Taking into account that some consumers have poor saving habits, and a tax refund is a method of forced savings for these Americans, allowing the federal government to hang onto your cash for months, or for longer than a year in some instances, without paying you a cent in interest, isn't a smart move. If you had properly adjusted your federal tax withholding during the year, your paychecks could have been bigger, allowing you to invest for your future, or pay down debt, which can grow with interest over time.

Conversely, owing a lot at the end of the year (usually in excess of $1,000) could net you an underpayment penalty from the IRS. Your goal every year should be to adjust your W-4 federal tax withholding to get as close to $0 owed/refunded as possible.



3. Keep good records
Third, you'll want to keep good records of potential deductions. Some consumers believe good tax records are only useful if you're being audited, but this just isn't the case. Yes, having good records is a must if you're facing a correspondence audit since an inability to provide the corresponding paperwork to back up your deductions could result in the loss of those deductions in their entirety. But good record keeping could also provide bigger discounts that you may not be aware of.

For example, you're required to report gambling winnings to the federal government as income. However, I'd be willing to bet that most consumers don't keep a detailed record of their losses at the casino, because who wants to dwell on that, right? Yet, those losses can be used to offset some, or all, of your gambling winnings, ultimately reducing your tax liability.

Good record keeping is especially important if you're self-employed. IRS data from 2010 showed that self-employed persons with $100,000 or more in gross receipts faced an audit rate of 4%, which is about four times higher than the average taxpayer at the time.



4. Invest for the long term
Tax filers seemingly have one mission once they begin preparing their taxes: find any (legal) means possible to lower their effective tax rates. The good news is that there's no shortage of deductions and credits available to the average taxpayer, including standard deductions, mortgage interest, and perhaps even child-based tax credits. But one of the easiest ways to lower your tax liability is to simply do nothing at all with your existing investments.

For the purposes of federal taxation, the IRS differentiates short-term investment holdings as an asset held for 365 days or less, and long-term investments as being held for 366 or more days. The difference in taxation between the two is significant. Short-term capital gains are taxed at the ordinary income tax rate, whereas long-term capital gains are taxed in three progressive brackets that feature a lower tax rate.

For example, assuming your short-term capital gains pushed your income over $37,650 for 2016; those gains would be taxed at 25%. Short-term capital gains could face taxation of up to 39.6%, not including the net investment income tax, which could tack on another 3.8% for individuals and couples earning more than $200,000 and $250,000, respectively.

Long-term capital gains are taxed at 0% if you fall into the 10% or 15% ordinary income brackets, 15% if you're in the 25%, 28%, 33%, or 35% ordinary income tax brackets, or 20% if you're in the highest ordinary income tax bracket. Hanging onto your investments over the long term is a smart tax-saving move.



5. File on time
This should probably go without saying, but the last federal income tax rule to live by is to file your tax return on time each and every year. If you fail to file a tax return and you owe the government money, you'll typically incur a penalty of 5% per month, with the penalty not to exceed 25% of your unpaid taxes. Also, if you fail to file for more than 60 days after Tax Day or your extension deadline, the IRS will hit you with a penalty of $135 or 100% of your unpaid taxes, whichever is smaller.

If you're self-employed, the penalties can be painful, even if you're owed money. If you fail to file a tax return as a self-employed person for a period of three years, you'll stop receiving Social Security credits toward your retirement, which could adversely impact your Social Security benefit once you retire.

Even if you owe money but don't have enough money to cover your tax liability, you should still file on time and work out a plan with the IRS. Doing so could come with monthly fees or penalties, but they'll be up to 10 times smaller than the penalty you'd face by failing to file in the first place.

Following these simply federal income tax rules will likely make Tax Day that much easier every year.

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