Dear Liz: Last year I bought an electric vehicle, motivated in part by the $7,500 federal tax credit. I consulted with my tax preparer, a CPA, to ensure I would generate enough income to fully use the one-time, use-it-or-lose-it credit. In December 2011, I informed her of the exact type of that year’s income (earned income, capital gains, dividends, interest and so on) and detailed all my deductions. She assured me that based on those numbers my tax burden was $8,600, more than sufficient to use the credit. It was enough, in fact, that I could use more deductions and losses, so I made some charitable contributions and sold a losing investment. The final numbers were very close to the estimates she received from me in December. Now that she has completed my federal tax return, however, my tax burden turns out to be far less than she estimated. In fact, it’s zero. Ordinarily I’d be delighted, but I specifically consulted with her to ensure I had a large-enough tax burden to use up the credit. I could have sold some winning investments to generate a bigger tax burden, but have now lost that credit forever. So far she has not responded fully to questions about what happened, and I now suspect she may simply have guessed at the tax burden and not run the numbers through any tax preparation software. I feel that she has in effect cost me $7,500. Am I right to be aggrieved and do I have any recourse?
Answer: Of course you’re right to be aggrieved. One of the reasons to hire a tax professional is to get good advice about managing your tax bill.
Human beings make errors, of course. No one is perfect. But it’s disturbing that your CPA hasn’t told you clearly why she made the mistake she did or, apparently, offered any kind of recompense.
When tax pro mistakes cost you money, it’s typically because the preparer underestimated your tax burden and the IRS catches the error. In that case, your tax pro shouldn’t be expected to pay the extra tax, since you would have owed the money anyway if she’d done the return correctly. But many tax preparers will offer to pay any penalties or interest the taxpayer owes because of their errors, said Eva Rosenberg, an enrolled agent who runs the TaxMama.com site.
In this case, of course, your pro overestimated your tax burden, ultimately costing you a valuable credit. You could always ask her to compensate you for some or all of that lost credit. At the very least, she should be willing to refund any fee she charged you for her advice, Rosenberg said.
You may want to review your own behavior to make sure you didn’t contribute to this situation. Given the amount at stake, you should have called to set up a formal appointment in which the two of you could go over the numbers and your previous year’s tax return, if she didn’t prepare it. That would ensure she had enough information to make a reasonable prediction. If instead you called her up with a “quick question” — tax questions are rarely quick, by the way, and the answers almost never are — then you helped set yourself up for a disappointing outcome.
In any case, you should find another tax pro, since this incident — and her handling of it — indicates she’s not quite up to the job of being your advisor.
Dear Liz: With tax time coming up, I have an important question. For years I have been told that the IRS has three years to audit you and after three years, supporting documentation can be shredded. But I read from other sources (including you) that we should wait seven years. So, which is it?
Answer: Your biggest risk of audit is definitely in the first three years after your tax return is due or the date it was filed, whichever deadline is later. But the IRS has another three years to audit you if it suspects you have underreported your income by 25% or more. (There’s no limit if it suspects you deliberately committed fraud.)
The seven-year recommendation stems from how we file tax returns — our 2011 return will be filed by April 2012, for example. Adding seven years to the year on the tax return should help most law-abiding taxpayers remember how long they need to hang on to supporting documentation.
Consult with your tax pro, but you may be able to save time and space by scanning your documents and keeping electronic, rather than physical, copies. The IRS accepts digital data as long as it can’t be altered.
Dear Liz: I am a 20-year-old college student with a stable, part-time job. I haven’t contributed to a 401(k) with this company because I don’t plan to be working for it for two years, which is how long I’d have to wait for my contributions and earnings to be 100% mine. I’d like to open a Roth IRA, but I’m not sure I’m eligible. I’m listed as a dependent and our household adjusted gross income is between $145,000 and $155,000. Can I open a Roth?
Answer: The short answer is yes, although you may want to reconsider contributing to your workplace 401(k) as well.
As long as you have earned income that’s less than the Roth limits, you can contribute to a Roth account, said Mark Luscombe, principal analyst for tax research firm CCH Inc. Your status as a dependent and your parents’ household income aren’t factors.
This fact allows many wealthier parents who make too much for their own Roth IRAs — the limits are $179,000 for a married couple filing jointly and $122,000 for singles — to give money to their lower-earning children to fund the kids’ Roth accounts.
“The dependent would need to have earned income for the year at least equal to or greater than the amount of the Roth IRA contribution,” Luscombe said. But “the Roth IRA contribution would not have to come from that earned income.” The money could come from the parents’ gift.
All that said, you should reconsider your aversion to your company’s 401(k), especially since you may be misunderstanding how it works. You typically would be able to leave with your own contributions, and the earnings on those contributions, at any time. What you may not be able to take with you is your employer’s full match, since it may take several years for you to be fully vested. Still, you may be able to leave with part of the match, which would make it free money that you shouldn’t turn down.
Dear Liz: I’m 25 and trying to maximize my tax savings and retirement contributions. I currently have two jobs: One is the typical salaried position with taxes withheld where I earn $45,000 a year, while the other is self-employed work I do on the side that grosses about $7,000 a year. Currently I have a Roth IRA that I max out and a 401(k) that gets the equivalent of 13% of my salary when combined with my employer’s contribution.
Given that I don’t get a refund on April 15 and end up having to pony up a lot of money, is there a way for me to set aside my self-employment income into a retirement account such that I can just bypass all taxes on it, including payroll taxes? Would a traditional IRA work that way? If so, how would the IRS know that I’m putting money aside from my self-employment income and not from my regular day-job income?
Answer: To answer your last question first, the IRS doesn’t really care where the money comes from when you pay your tax bill. It mostly just cares about getting paid.
That said, you probably won’t be able to avoid self-employment taxes on your side business income, although you should be able to reduce or even eliminate owing income taxes on the money, said Eva Rosenberg, an enrolled agent who writes about taxes at TaxMama.com. (Self-employment taxes are your contributions to Social Security and Medicare.)
“The only way to reduce self-employment taxes is to reduce self-employment income,” Rosenberg said. “Putting money into retirement plans of any kind will only reduce income taxes.”
One way to reduce your self-employment income is to incorporate and then have your corporation contribute to your retirement plan directly, “thus wiping out most of your wages,” Rosenberg said. “However, the cost of incorporating and the annual filing and fees related to all that will certainly exceed your self-employment taxes on $7,000.”
What might make more sense if you want to reduce your income taxes is to contribute the maximum $5,000 to a traditional IRA, which offers a tax deduction for contributions, instead of funding a Roth, which does not. Even though you have a retirement plan at work, you can deduct your full contribution if your modified adjusted gross income is under $56,000.
Another option is a solo 401(k), which would allow you to put aside up to 100% of your compensation (although again, you would still owe self-employment taxes on that compensation).
Also, if you expect to owe more than $1,000 at tax time, you should be making quarterly estimated tax payments instead of waiting until April 15 to pay your tax bill.
Dear Liz: I’ve seen some writers suggest that people can destroy financial and tax information after three years. Let me tell you my story. Before my sister died, I had to take care of her finances. She had little money left but she had to go into an assisted-living facility. I had to show proof of five years’ earnings and financial statements. So please tell people not to shred or discard information after three years.
Answer: It sounds as if you were getting your sister qualified for Medicaid, the government program that covers health and custodial care for the indigent. Medicaid now has a five-year “look back” period that penalizes transfers of money or assets when people apply for coverage. The look-back period is designed to discourage people from artificially impoverishing themselves by transferring assets to others so that they can qualify for Medicaid to cover nursing home bills.
You’re right that destroying financial documents after three years may be a bit precipitous. The IRS typically has three years from the due date of the return, or the date it was filed, whichever is later, to conduct most audits. But the deadline can be extended an additional three years if the IRS believes you significantly underreported income. And certain documents need to be retained longer. That’s why many tax experts recommend hanging on to supporting documents for your tax return for at least seven years, and keeping the tax returns themselves indefinitely. You also might consider scanning important financial documentation into your computer and keeping back-ups offsite.
The good news is that many of the statements you’re likely to need can be reordered from the financial institution that originally issued them. There may be fees involved, but many banks, brokerages and credit card firms easily can provide you with statements dating back six years, if not longer.
Dear Liz: I read your column about the reader whose tax papers were missing and couldn’t believe my eyes. A similar thing happened with me. My accountant mailed my returns to me as always, but this time they did not arrive the next day as they always did. I was worried sick because, of course, the Social Security numbers and all of our banks are listed in the returns. I was very worried that someone had stolen our returns and would use them either for identity theft or to drain our bank accounts. I filed a theft report with the Postal Service and fraud alerts with credit reporting agencies. Three long weeks later, I got an envelope from the IRS with the returns in it, requesting the missing signatures on the returns. Apparently the returns had been sent to the IRS rather than to us. I strongly suspect there is a flaw in the software the accountants are using this year that is sending the returns directly to the IRS instead of to the accountants’ clients for signatures. If you have the email address of your reader, please have him or her call the IRS, and I bet they have the return and all of the original paperwork.
Answer: Actually, the reader followed up to say her supporting paperwork eventually made its way to her mailbox. The return itself, as noted in the column, was electronically filed without her permission or review.
Whether there’s a software glitch or simply overworked preparers making mistakes is unclear. But these experiences do highlight the risks of using the U.S. mail for sensitive information. Here are another reader’s thoughts on the subject:
Dear Liz: As a tax preparer, I deal with clients who live 100 or more miles away, and I have never had a problem with mailing of documents in either direction. Perhaps they may be delayed somewhat, but they have always arrived. As to the issue of the preparer filing electronically without permission, the IRS mandates that a return can be filed electronically only after the preparer receives the taxpayers’ approval (IRS Form 8879 must be signed by the client). Therefore it appears that the tax preparer in this case may have acted in a manner not acceptable by taxing agencies. This is something taxpayers should be wary of in dealing with tax preparers.
Answer: That’s definitely true, but perhaps you should consider being a little more wary of the mail system. Just because nothing has happened yet to all that sensitive data doesn’t mean something can’t or won’t. It may cost a little more, but if your clients can’t drop off information and pick it up themselves, paying for delivery services that offer tracking information is a way to make these transactions more secure.
Dear Liz: I sent my tax preparer everything he needed for my return, including the originals of my W2 forms, bank 1099s, property tax bills (including a copy of the check showing the payment) and a year-end mortgage statement. A week later he said it was done and that he had mailed the return and paperwork back to me. It’s been three weeks and I still haven’t received the paperwork. What I did get was a direct deposit of my refund, so apparently he filed the return without telling me. I am sick to death that all my private financial information is floating around in the mail system somewhere and that it could get into the hands of a dishonest person.
Answer: You’ve learned a couple lessons, foremost among them that you need a new tax pro. Filing your return without letting you see it was a definite no-no.
Another lesson is that your private financial data probably shouldn’t be entrusted to the U.S. mail system. It’s more secure to drop your documents off with your tax preparer and pick them up yourself, along with a copy of your return, when he or she is done. The original return can be electronically filed using the IRS’ secure, encrypted system, eliminating the need to use the mail.
You can put 90-day fraud alerts on your credit reports at the three major bureaus (Experian, Equifax and TransUnion). Fraud alerts notify lenders that they should take extra steps to verify identity before opening accounts in your name. For more protection, you may want to consider a credit freeze, which doesn’t rely on lenders’ sometimes-wavering vigilance but that allows you to shut off access to your credit reports, preventing thieves from opening new credit accounts. For more information, visit the Consumers Union site www.financialprivacynow.org.
Dear Liz: My father died in June, and I inherited part of his stock portfolio. I understand in 2010 there is no estate tax but have heard different opinions (from my tax advisor and two financial advisors) as to what my tax basis will be when the stocks eventually are sold. The opinions are that 1) I will get no step-up in tax basis, so that I will pay tax on the difference between the sale price and what Dad paid for the stocks; 2) that I will get a 100% step-up, so that the stocks will get a new basis based on their value at Dad’s death, which would minimize capital gains taxes; or 3) some combination of the two — basically, a certain portion would have the step-up allowed and the balance would not be eligible for the step-up. Can you clarify?
Answer: You’ll need to talk to the executor of your dad’s estate.
Here’s why. When there is an estate tax in place, the assets in people’s estates get “stepped up” to their value at the time of the person’s death. This is a huge boon to the vast majority of estates. Most people’s estates don’t owe estate taxes, but they still get this favorable tax treatment so that no tax is paid on the gains that occurred during the person’s lifetime.
When the estate tax disappeared for 2010, the step-up rules changed as well. Each estate instead is allowed $1.3 million of step-up, which the executor can allocate any way he or she wants, said estate attorney Burton A. Mitchell of Jeffer Mangels Butler & Mitchell in Los Angeles, although no asset can receive a step-up that’s more than its fair market value.
If your father’s estate had less than $1.3 million of unrealized capital gains, then all of your inherited portfolio gets a step-up in tax basis. If the gains exceed that amount, however, some or none of the portfolio would get the step-up, depending on the executor’s decision.
The executor has to file a form with the IRS outlining how the step-up is allocated. This form is due with the decedent’s final income tax return, Mitchell said.