As a Wealth Advisor, I've reviewed hundreds of client tax returns over the years. Unfortunately, even as tax prep software evolves, several common mistakes prevail and every year I catch a few. So how can you avoid these common (and costly) errors?
Remember Charitable Distributions
Taxpayers over 70.5 years old can distribute IRA funds directly to charity, free of tax. This maneuver is known as a Qualified Charitable Distribution, or QCD for short. The allure of QCDs is that they count toward the taxpayer's Required Minimum Distribution (RMD). Many of our retired clients use this strategy to fulfill their charitable giving in a tax-efficient manner.
Utilizing Qualified Charitable Distributions is a great strategy, but it is often overlooked on the client's tax return. The issue lies in communication. Custodians like Charles Schwab and Fidelity are in charge of providing tax forms like 1099s to their investors. For example, a 1099-R is created when money leaves an IRA. The 1099-R covers important details such as the amount distributed, taxes withheld, and codes that determine whether the 10% penalty or other circumstances apply.
Notably, the amount given to the charity is not included on Form 1099-R. Therefore, the taxpayer must keep a detailed record of calendar year QCDs and remember to share that information with their tax preparer. Unfortunately, there isn’t anything on the 1099-R that will alert the tax preparer of the QCDs so communication is critical. The 1099-R alone will not paint the full picture. Failure to report QCDs will result in a higher tax bill because you're paying income taxes on funds that should be exempt.
Backdoor Roth IRA Reporting
High-income earners often use the backdoor Roth IRA strategy to save for retirement. This strategy consists of making after-tax (aka non-deductible) IRA contributions that are later converted to a Roth IRA. The conversion is tax-free if the taxpayer does not have additional pre-tax money in an IRA. The mechanics are relatively simple, but the tax reporting can be tricky.
Recording a backdoor Roth IRA contribution can go sideways in several ways. Non-deductible IRA contributions and Roth conversions are recorded on Form 8606, which is the source of most errors related to this topic. Most commonly, I see the incorrect accrual of after-tax basis, incomplete filing, or omission of the form entirely.
A Roth conversion is technically an IRA distribution. Which means the taxpayer will receive a 1099-R from the custodian. Some taxpayers can convert tax-free, while those with pre-tax money in IRAs will owe tax pro-rata. If the after-tax basis is misreported on Form 8606 or the form is missing completely, it may trigger taxes when taxes are not owed. The bottom line is that it's easy to get this crucial step wrong. Consult with a tax professional if you want to get it right.
Pesky Underpayment Penalties
Even though taxes are technically due at the filing deadline, the IRS expects taxpayers to make payments throughout the year. Wage earners do so by withholding taxes from their paychecks. Retirees typically satisfy this requirement by withholding taxes from IRA distributions or Social Security. In addition, self-employed individuals often make estimated quarterly payments. However, sometimes these methods are not enough.
The IRS levies an underpayment penalty on filers who do not pay the lesser of 90% of the current year's tax or 100-110% of last year's tax, depending on adjusted gross income. The penalty is based on interest rates and changes quarterly, with a floor of 3%. Most people I know don't enjoy paying a tax bill, so the underpayment penalty is often like pouring salt on an open wound.
If you're a W-2 employee and face underpayment penalties, consider updating your W-4 with your company's Human Resources department. This will increase the tax withholding on your paychecks. Retirees withholding through IRA distributions should reassess their withholding percentage annually. It's likely that individuals who pay quarterly estimates already partner with a tax preparer. To optimize that partnership, keep them updated on how the business is doing throughout the year.
Portfolio income can sometimes contribute to the underpayment issue. Therefore, investors and advisors should be sure to communicate when substantial capital gains are realized so that taxpayers can get ahead of the tax bill.
It's easy for the average person to make mistakes when filing their taxes. Partner with a qualified tax professional if you're making Qualified Charitable Distributions, using the backdoor Roth IRA strategy, or consistently owe the government taxes.
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