Lots of people like being right. But in the tax world, just like in other situations, being right isn’t always enough.
A good friend recently asked me to review his tax return before he submitted it to the IRS. I did and I noticed something that I didn’t love – a huge refund (and I mean huge). This follows on the heels of a huge refund last year. Last year, I advised him to adjust his withholding so as not to get another big refund. He didn’t and lo and behold, he ended up with the same situation – only this year, he made less money and had more withholding so that his refund is even more than last year.
Notwithstanding the economics of getting a big refund (why would you want the government to hang onto your money for nearly a year without paying you interest?), my concern was that his refund was out of sync with his tax bracket. His refund is more than 10% of his income. And he has a six figure income.
He argued with me for a bit that all of his deductions were justified. I argued back that I wasn’t questioning his deductions, that I was sure he was right, but that still didn’t mean that he wasn’t putting himself at risk for an audit.
To be clear, audits are not common. And I do not believe that you should go to bed at night overly worried about being contacted by the IRS for minor issues or discrepancies. I’ve even posted about this before – I believe it is your right to be aggressive on your returns (so long as you can substantiate it) and you have no responsibility to pay more than you need to.
But you also need to be smart – there are things that will get your tax return noticed by the IRS when you don’t want it to be. Don’t be careless. Don’t be piggy – if you can’t back it up, for example, don’t claim it.
And in my friend’s case, there is something that he needs to understand. Things that IRS may look for when reviewing data are odd patterns, wild deviations from your prior years’ returns and wild deviations from other folks’ returns in your same income bracket. If you stand out for one of those reasons, does that mean you’re doing something wrong? Of course not. But it does mean that these patterns are enough to give IRS pause – and why would you want to do that?
Every taxpayer is different. But the IRS can usually predict behaviors within certain parameters based on statistics. If it strikes the IRS as odd that your deductions are $25,000 more than taxpayers in your bracket, it may – but not necessarily – strike interest.
And at audit, you’d have the opportunity to prove that you’re right if you really are right – but why would you put yourself in that position to begin with if it were avoidable?
So what can you do about it?
Again, be smart.
With respect to refunds, don’t use the IRS as a savings account. Make adjustments from year to year with respect to your withholding if you are aware of changes that will affect your tax return. If, for example, you take a substantial pay cut, make the necessary changes on your W-4. Of course, if you don’t do so in the first year, don’t panic but if your information is going to be consistently different, consider making a change.
And vice versa. If you get a one time boost in your income – and you forget to make an adjustment – it’s not the end of the world. But, if you get a huge increase in pay or your spouse goes to work full time, look at your tax picture and plan accordingly. You may need to make estimated payments, for example.
A good rule of thumb is that most significant life changes – marriage, babies, new jobs, retirement, disability – will affect your overall tax picture. Your withholding as a single guy working at Burger King and living in an apartment is not the same as your withholding as a married father of three kids with a mortgage payment. Additionally, changes in tax legislation can affect your tax situation.
If you’re not sure whether you need to make a change, consult with a qualified tax professional.
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