Whether due to avoidable penalties or because they failed to claim a tax deduction for which they were entitled, many taxpayers this year will make a check out to the Internal Revenue Service for more than they actually owe.
“Modern tax-planning software is making it easier for the average person to file their taxes accurately, so they’re not missing as many tax breaks as before, but there are still a few areas where we see mistakes,” said Skip Johnson, a partner with Great Waters Financial in Minneapolis, Minnesota, in an email interview.
Take note that overpaying your tax bill is not the same as withholding too much from your monthly paychecks, which results in a refund when you file your tax return. If you forget to claim a deduction or get hit with a fee for not following the rules, it’s (generally) a loss to you.
- Filing penalties
- RMDs, Social Security
- Tax-deferred accounts
- Interest rate strategy
- Tax breaks on the table
- Reinvested dividends
- Charitable donations
Late filing, payment penalties
Millions of taxpayers get hit with tax-filing penalties each year.1 The most common reasons are for failure to file on time, late payment, and tax return preparation mistakes like forgetting to sign their return or math errors, which force the IRS to send it back for a correction without enough time to resubmit before the deadline.
The penalty for failure to file by the deadline, which is among the most costly penalties, is 5 percent of the unpaid taxes for each month or part of a month that your tax return is late, increasing up to 25 percent of unpaid taxes.2
The late payment penalty, by contrast, is more forgiving. The IRS is often willing to work out an installment plan if you can’t come up with the cash by the mid-April deadline. You will normally face a failure-to-pay penalty of one half of 1 percent of your unpaid tax bill for each month or part of a month after the due date. If you request an extension of time to file your tax return before the deadline and paid at least 90 percent of the taxes you owe for the year, you may not face a failure-to-pay penalty. But you must pay the remaining balance by the extended due date, plus interest.
Another common tax-filing penalty that is easy to avoid is an estimated tax penalty. Some 10 million taxpayers are assessed such penalties every year. To avoid it, you must generally pay either 90 percent of your total tax liability for the year, or 100 percent of the amount you owed in the prior tax year through income tax withholding or by making estimated quarterly payments.
The IRS applies a penalty rate (or percentage) to calculate the size of your penalty, based primarily on how much you owe. But any extra payment is money down the drain. Independent contractors and those who are paid sporadically, in particular, should monitor their tax liability and payments throughout the year.
RMDs and Social Security snafus
Retirees must begin taking required minimum distributions (RMDs) from their tax-deferred IRA in the year they turn age 73 (the new age limit under the SECURE 2.0 Act), although this requirement can be postponed until April of the following year. Failure to take RMDs, either because they forgot or because they miscalculated how much they owe, can result in an onerous 50 percent penalty of the amount not withdrawn.
The original 2019 SECURE Act raised the age at which RMDs must begin to 72 from age 70 ½. The new SECURE 2.0 provisions raised that age limit again to 73 beginning on January 1, 2023, and to 75 in 2033.Those approaching RMD age should take special care to ensure that they are on track to pay what they owe. A financial professional or tax preparer can help. (Find a financial professional near you)
New retirees who transition from collecting a regular paycheck to converting their savings into a regular income stream must also be mindful of the taxes they will owe, said Johnson.
Money withdrawn from tax-deferred savings accounts like 401(k)s and traditional IRAs, of course, is subject to ordinary income tax (plus a 10 percent early withdrawal penalty if you are under age 59 ½, unless you meet certain exemptions).
“People who are newly retired and have always had money withheld for taxes by their employer sometimes forget about taxes when they start taking money out of their IRAs,” he said, noting that can result in a nasty surprise, or in some cases, a penalty if they can’t pay what they owe. “We suggest making estimated payments in retirement.” (Learn more: RMDs in retirement)
Another important point: The amount of your combined taxable income in retirement affects how much of your Social Security benefit is subject to taxation, which can be anywhere from 0 to 50 percent, or even 85 percent in certain cases.
For tax year 2023, married couples filing jointly will pay federal income taxes on up to 50 percent of their Social Security income if they have a combined income from between $32,000 to $44,000. If they exceed that limit, up to 85 percent of their Social Security benefit will be subject to taxation.3
“The higher you push your gross income, the more of your Social Security [check] is subject to income tax,” said Johnson. “If you’re not planning for that and paying attention to those limits, you can be surprised to find that you owe a lot more taxes than you expected.”
Retirees can potentially reduce the amount of Social Security tax they pay by managing their withdrawals from a combination of nontaxable accounts (like Roth IRAs) and tax-deferred accounts (401(k)s and traditional IRAs), said Johnson, who suggests working with a tax preparer or financial professional to maximize the size of your Social Security benefit.
Underfunding tax-deferred accounts
Tax-deferred accounts are one of the most effective ways to minimize your taxable income, while building financial security.
Your 401(k) and traditional IRA are funded with pretax dollars, which reduces the amount of tax you will owe in the year you contribute.
The 401(k) contribution limit is $22,500 for tax year 2023 and $23,000 for 2024. If you are age 50 or older you may make additional catch-up contributions of up to $6,500 in 2022 and $7,500 in 2023.
The contribution limit for IRAs in tax year 2023 is $6,500 and $7,000 in 2024, with an additional catch-up contribution allowance of $1,000 if you are age 50 or older. The amount you may deduct, however, is subject to income phaseout limits and whether you are covered by a workplace retirement plan.
For married taxpayers filing jointly, where the spouse making the IRA contribution is covered by a workplace retirement plan, the phase-out range is $116,000 to $136,000 for tax year 2023 ($123,000 to $143,000 for tax year 2024.)4
Similarly, contributions to a health savings account, or HSA, for those who are enrolled in a high-deductible health plan can reduce your taxable income.
HSAs are funded with pretax payroll deductions and the earnings become tax free if used to pay for qualified medical expenses. Unlike a flexible spending account, or FSA, contributions to which must be used or forfeited at the end of each year, contributions to an HSA accumulate. They can be used to cover current health care bills or saved for future use, including during retirement when medical bills are typically higher. (Learn more: Health savings accounts for retirement planning)
Many HSA plans allow plan participants to invest a portion of their account balance in brokerage accounts to seek higher returns. (Be aware that any investment in securities such as stocks, bonds, or mutual funds involves risk.)
For tax year 2023, families may contribute up to $7,750 to an HSA. That limit rises to $8,300 in 2024. The more you contribute to tax-deferred accounts each year, the more tax dollars you save.
Interest rate oversight
With interest rates on the rise, Johnson said his firm is seeing an uptick in individuals who are giving up more than they should because they are not taking advantage of tax-friendly savings strategies.
“People are getting decent interest rates again on Certificates of Deposit and other banking instruments, but that interest is taxed as ordinary income,” he said, noting ordinary income tax rates are higher for many Americans than the capital gains tax rate, which caps out at 20 percent.
As a result, taxpayers who have parked some of their savings in a CD and don’t immediately need the gains may be paying a higher tax than necessary, said Johnson.
“You could potentially get a similar interest rate in a similarly conservative product, but pay less tax, by repositioning that money into an annuity (which is tax-deferred), a Roth IRA (which is funded with after-tax dollars, but offers tax-free growth), or even municipal bonds, which actually end up federally and possibly state income tax free,” he said.
To determine the best saving and investment strategy for you, however, it may be best to consult a financial professional.
Forgotten tax credits, deductions
Tax credits and deductions can potentially reduce your tax liability significantly, but only if you claim them.
Many individuals fail to claim all the tax breaks to which they are entitled, especially new ones that they do not yet understand or existing credits that they fear may raise a red flag for an audit, said Mark Luscombe, principal tax analyst for Wolters Kluwer in Riverwoods, Illinois, in an email interview.
For example, most parents are well aware of the Child Tax Credit, but they are still unclear on the newer $500 credit for “other dependents” who do not qualify for the Child Tax Credit.
Luscombe said many homeowners forget to include points paid at closing in their mortgage interest deduction, while other taxpayers fail to consider some of the less obvious medical expenses, which may be deductible, including equipment for disabled persons, substance abuse programs, certain weight-loss programs, smoking cessation programs, and transportation to and from medical appointments.
A tax credit is more valuable than a deduction because it provides a dollar-for-dollar reduction of your income tax liability, while a deduction reduces the amount of your income that is subject to taxation. But both can lower your tax bill.
Some of the most valuable credits and deductions that taxpayers who qualify should claim include the Earned Income Tax Credit, which is worth up to $7,430 in tax year 2023 for families with three or more children, and the Child and Dependent Care Tax Credit, which is worth from 20 percent to 35 percent of your allowable expenses for child or day care, up to an annual limit.
“Many people fail to keep track of day care expenses, including summer day camp expenses, or fail to obtain taxpayer identification numbers from day care providers, so that they can claim the Child and Dependent Care Credit,” said Luscombe.
The Saver’s Credit, for low- and moderate-income workers, also provides a credit of 10 percent to 50 percent (depending on your income) of your retirement plan or IRA contributions up to $2,000 ($4,000 for married taxpayers filing jointly.)
If you forget to claim a deduction this year, or have done so in the recent past, never fear. The IRS and many states allow you to file an amended tax return to claim those credits retroactively for up to three years.5
When you sell a mutual fund, you pay taxes on the capital gain, which is calculated by subtracting the amount of money you paid for those shares (your “cost basis”) from the sales price.
If your mutual fund pays dividends, however, and you automatically reinvested those dividends to buy more shares, you slowly increased your cost basis with each new purchase. Why? Because you already paid taxes on that dividend when it was distributed.
Many taxpayers forget to factor in reinvested dividends when they sell those shares, which results in an artificially higher tax bill. Look closely at your securities transactions to ensure you are not paying more than you should.
Wealthy taxpayers who are philanthropically inclined make a potentially costly mistake when they make a cash donation to a favorite charity.
By donating appreciated stocks or securities instead, they can claim a tax deduction equal to the full market value (subject to limits and provided they itemize), as long as the asset was owned for at least a year. In addition, if you donate stocks or other investments, you may not pay any capital gains tax.
Donors can also gift their permanent life insurance policy to a charity, if it is no longer needed, which may yield an income tax deduction. The donor can instead name the charity as a beneficiary under the policy, so that he or she has continued access to the policy’s cash value. (Learn more: Using life insurance for charity)
As always, it’s wise to plan your charitable giving with help from a qualified tax or financial professional, who can help you make the most of your generosity.
No one wants to pay the federal government more than they owe. By avoiding penalties, saving smart, and leaving no tax deduction or credit stone unturned, you can potentially put more jingle in your pocket this tax-filing season. How you choose to use those savings is up to you.
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This article was originally published in March 2020. It has been updated.