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.
10% of his income? That doesn’t sound so bad. But, what I wonder is if you have the same pattern year after year each time, will the IRS see that pattern and then flog you if it changes?
And you mention that audits aren’t common…it seems like every third person you talk to 1.) has been audited by the IRS or 2.) is about to be audited by the IRS.
I read your post on things that flag the IRS sniffers and can cause potential problems, but I think it’s just most folks nagging fear is that they will get “the notice” in the mail and ask to bring in their brown paper bag of receipts.
And one more ramble: if you do your taxes, pay the IRS or get a refund back, can they come back after that and STILL audit you? Wouldn’t they have caught any discrepancies before they give you the refund?
OK, that’s it taxgirl. What do you think?
If the audit argument doesn’t get him, point out to your friend that for the last year he’s given Uncle Sam a hefty, INTEREST-FREE loan. I’m in the same boat: Went freelance last year, had to pay estimated taxes, and overestimated by a large amount. That won’t happen this year. I love my uncle, but not enough to loan him that kind of scratch.
Tom –
I agree! If you owe Uncle Sam, you pay interest. If he owes you, he doesn’t pay you interest. You don’t want to be in a situation where Uncle Sam has a lot of your money, interest-free.
That’s one of my frustrations with the RALs (refund anticipation loans), too. I know folks that are DYING to get their refunds and will therefore cough up more than 100% interest for a loan to get it quicker – if you just make a few changes in your tax planning, you could have that money throughout the year.
Bridget –
Re the size of the refund, I wasn’t so much stressing the 10% as the idea that the size of the refund is very large. And notwithstanding the economics (again, pointed out by Tom), for the income bracket, I think the refund is above average. That would worry me.
But more importantly, your question about audits… Absolutely! The IRS merely processes returns at a first go. You could well be issued a refund that the IRS later believes you are not entitled to – and asks for it back (plus interest). You should never assume that if you get your refund back, there’s no problem – especially if you are aware of issues on your return. Absent fraud or substantial under-reporting (both of which increase the statute of limitations), the IRS may review your return for up to three years after you submit it.