Tame Your Tax Paperwork

We all know "that guy" -- the one whose filing system is so organized he still has a folder for "Receipts: Laptop Upgrades -- 1998." If you're "that guy," don't feel obliged to keep reading. This article's for the rest of us who, despite poking fun at your fussbudget ways, secretly wish we were a little more like you. Especially now.

Tax time is looming (those year-end financial statements were your first clue; the litany of H&R Block ads were the second), and there's no better time to start taming that pile of Very Important Papers Pertaining to Your Taxes.

The cost of disorderly conduct

Organization isn't just good for your sanity. It also has financial rewards. According to the General Accounting Office, the average taxpayer overpaid the IRS $438 in 1998 (the most recent stats available) by overlooking deductions and missing opportunities to itemize. About one quarter of all taxpayers may have been owed more than $500.

How exactly does that happen? It mostly boils down to deductions that have been overlooked and credits -- often tax breaks -- that are hiding in plain sight (albeit obscured by thick forestry of W-2s, 1099s, and quarterly and year-end statements).

The three-folder system

If the "pile it and file it later" approach isn't working for you, consider revamping your personal paper trail and you might just save a few tax dollars come April.

Try the following three-folder method. Consider it a starting point -- a basic organizational approach that, depending on the complexity of your taxes, you can modify to suit your needs.

Folder 1: Income

What goes here: Every penny you earn that is reported to the IRS (salary, dividends, earnings, distributions, even that paltry $3.42 in checking account interest) comes with a paper trail. To keep it all straight, write all income sources (and amounts earned) on a single sheet in your "Income" folder as they occur. (Yeah, it's easier to do as the year progresses, so vow to start doing it for the rest of '07.)

IRS prep work: As corresponding records of interest, earnings, distributions, and dividends arrive (e.g., 1099s and W-2s), verify their accuracy and check each off on your income cover sheet. These official docs (for everything from freelance work, jury duty payments, and nearly every investment transaction) should have everything you need to account for income when you do your taxes. (Note: Some 1099s will be reported to the IRS immediately after a taxable event, such as savings bond redemptions and gambling winnings. Don't forget those come April; the IRS certainly won't.)

Folder 2: Expenses/Deductions

What goes here: The amount of deduction detritus can quickly dwarf the Manhattan phone book. Take lots of deductions? Create separate files for the major categories (e.g. charity, medical, business) where cancelled checks, utility bills, statements, and receipts go. If that's more than you need, establish a single catchall envelope for records related to the current tax year. Here you'll keep mortgage statements, investment-related expenses, medical bills, childcare costs, and nonreimbursable/employment-related gas, food, and lodging receipts.

IRS prep work: Uncle Sam offers a "standard deduction" to most taxpayers ($5,150 for single or married, filing separately; $10,300 for married, filing jointly/surviving spouse; and $7,550 for heads of households). Many states, however, are not as generous. Before you bother itemizing, eyeball your biggest potential deductions and see how close you come to the state and federal standard deduction allowances. (Many taxpayers itemize on one and not the other.) Not even in the ballpark on either? Take Uncle Sam's offer and call it a day. (Be sure to note any itemized deductions that can be carried over to future returns, such as capital losses that exceeded the limit last year.)

Folder 3: Investments

What goes here: Would that the year-end statement was a sufficient record of annual account activity. Alas, it's not always. That's why we get monthly/quarterly/annual statements, purchase receipts, sale confirmations, year-end overviews, dividend notices. Oh my! To add to the confusion, the IRS isn't even interested in certain records until you dispose of the investment (which could be decades for some investors).

The easiest way to segregate investing paperwork is by how it's taxed. Create separate folders for:

• Deductible/tax-deferred investments -- records that prove your annual contributions to qualified retirement plans; Roth contribution records (so you aren't taxed twice); and distribution records (1099s) once you start taking distributions.

• Nondeductible investments -- records for IRA contributions that are ineligible for preferential tax treatment.

• Taxable investments -- statements (or confirmation slips) that prove the cost basis of your investment (reinvested dividends, capital gains, capital losses, mergers, 1099s, and K-1 forms). Thankfully, most brokers issue combined 1099s for those with multiple brokerage accounts. Note for long-term buy-and-holders: Create separate folders for each stock. Your tax pro (if you use one) will cry tears of joy -- reflected in a lower tax-prep bill.

IRS prep work: Purchases, losses, interest, dividends, sales -- all stock-related activity --  will generate corresponding 1099s (or K-1 forms for certain trusts or partnerships) that the IRS will get, too. Keep proof of purchase (trade confirmation or annual statement); dividends paid; split/merger/buyout notices; deductible investment expenses; and proof of security received as a gift or inheritance until you sell.

Dayana Yochim's favorite organization system is color coordination, though when it comes to money paperwork, she's OK with manila folder-minimalism. She is the advisor of www.GreenLight.Fool.com, which, as the name implies, is dedicated to helping people make more of the green stuff (non-vegetable variety).