Ten Common Tax Misconceptions

The Wall Street Journal

The tax code has gotten so complicated that even smart people make big mistakes about filing taxes, according to the National Association of Enrolled Agents. Here’s a list of taxpayers’ common misconceptions gathered by enrolled agents across the country. (Enrolled agents, by the way, are allowed to represent taxpayers before the Internal Revenue Service, after passing a stiff competency exam and a background check; they also prepare tax returns.)

1. “I’m filing an extension this year, so I don’t need to pay anything yet.”

When an extension is filed, it is just an extension on the time to file; it is not an extension on the time to pay! If a taxpayer owes $1,000 on a personal return and files an extension, he or she has until Oct. 15 to file the return. But if the $1,000 is still owed by April 18 (taxes are due on April 17 this year), interest and penalties start to accrue. To avoid paying a penalty, you must pay at least 90% of what you estimate you owe or 100% of your 2011 tax liability prior to April 18.

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If you don’t pay in full, you’ll wind up owing interest and possibly penalties on the liability not covered. The IRS did recently announce that it would allow some struggling taxpayers a six-month grace period. For details, click here.

2. “I had a big loss in the stock market this year, so I won’t owe any income taxes.”

The deduction of capital losses against ordinary income is limited to $3,000.

3. “I traded some stocks and have a loss/didn’t make any money, so there’s no need to report those sales.”

The sales must be reported on the taxpayer’s return. If the stocks were bought in 2011 or after, both the broker and taxpayer must provide the “cost basis” (often the purchase price) to the IRS as well. Brokers provide this information to taxpayers, but they should check carefully to make sure it is correct. This is the first year brokers have had to report cost basis, and there have been reports of mistakes. 

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4. “I reinvested my dividends and didn’t receive them, so I don’t have to pay tax on them.”

Wrong. Whether you receive them or reinvest them, they are income.

5. “They paid me in cash and I don’t have to report it.”

If it’s income, you must report it.

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6. “I’m too young/too old to have to pay taxes.”

Even a dependent high school student has to file a return after earning income over $5,700. And Uncle Sam may still be interested in your return after you’re dead. A personal representative of the decedent is required to file a final personal tax return, and possibly an estate-tax return, and pay the taxes due.

7. “If I didn’t receive a document about it, it’s not taxable.”

A good tax preparer will provide a checklist for missing documents, but too often taxpayers who prepare their own returns will fail to include important information simply because they missed something in the mail, or the document was never mailed.

8. “Income earned in a foreign country is not taxable.”

Taxpayers are required to report all earned income to the IRS, no matter where it was earned. Taxpayers can face huge penalties for not reporting foreign financial accounts or income earned abroad.

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9. “Income from my hobby can’t be taxable.”

The operative word here is “income.” It’s taxable.

10. “The IRS doesn’t care about my state tax refund.”

Taxpayers who itemize their deductions are allowed to deduct all state taxes paid or withheld on their federal return, so in reality, paying taxes on last year’s refund is correcting an over-deduction from the previous year.

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