Retirees: How To Avoid A Tax Audit
Dear Rich Lifer,
If you’re in your forties, you have about the same chance of dying from COVID-19 that you do of being audited by the IRS.
Last year, the IRS audited 0.4% of all individual tax returns, and 80% of these exams were conducted by mail.
We expect those numbers to be even lower this year due to looser enforcement by the IRS in light of the coronavirus pandemic.
But like the mortality rate with COVID-19, your chances of complications increase with certain comorbidities.
The IRS pays particular attention to certain deductions and claims retirees make. If you want to reduce your chances of being flagged by the IRS, pay special attention to these 7 tax audit red flags.
1. Not Taking Your RMD
When you turn 70 and a half, the federal government requires you start drawing a minimum amount from certain types of retirement plans.
These are called required minimum distributions (RMD). If you don’t take your RMDs, you owe a penalty. How much?
If you fail to take out your RMD by the deadline, you will owe 50% tax on the amount not withdrawn.
The IRS knows how old you are, so don’t think you can get around this rule. Failing to pay will place you on their radar.
2. Not Reporting All Taxable Income
When you retire, you’ll likely be funding your daily expenses through various sources of income. Make sure you don’t overlook any of these sources when filing your tax return.
The IRS gets copies of all the 1099s and W-2s you receive. Including reporting payouts from retirement plans, pensions, 401(k)s and IRAs, as well as your Social Security benefits.
If your numbers don’t match up to what the IRS’s computers are showing, your return might get flagged and a bill will be issued.
So, make sure you report all taxable income, especially if it’s from a part-time job like driving for Uber, selling crafts, tutoring or some other hobby-business.
3. Taking Early Withdrawals
If you forget to take your minimum required distributions, Uncle Sam will penalize you. If you take your retirement money too early, Uncle Sam will also penalize you.
While the penalty is not as severe as a late withdrawal, there is still 10% tax on withdrawals made before age 59 and a half, unless you qualify for an exception.
Exceptions include: first time home buyers, military, education, IRA rollovers etc. See the full list on the IRS’s website here.
4. Reporting Big Losses
Another red flag retirees often overlook is reporting large losses. Especially, retirees who enjoy gambling need to report any winnings as income if they plan to also report losses as an itemized deduction.
Similarly, retirees who run small businesses need to make sure they are not reporting business expenses without any income to show for.
If you fail to report a profit in three of the last five years, the IRS will consider your business recreational and could have some questions for you.
5. Making Lots of Money
Like we pointed out earlier, the odds of actually being audited are relatively low. However, the more money you make, the odds of being audited increase.
In 2019, people with incomes between $200,000 and $1 million who did not file a Schedule C had an audit rate of 0.4%. If you did file a Schedule C, the audit rate jumped to 1%. If you reported $1 million or more, your chances of being audited were 2.4%.
There’s nothing wrong with making lots of money, just know your chances of being audited increase the more you report.
6. Claiming Large Rental Losses
An easy way to get the attention of the IRS is to claim a big loss on a rental property. Typically, the passive loss rules prevent the deduction of rental real estate losses. However, two exceptions apply.
If you actively participate in the renting of your property, you can deduct up to $25,000 of loss against your other income. This deduction phases out at higher income levels.
The second exception applies to real estate professionals who spend more than 50% of their working hours and more than 750 hours each year participating in real estate as developers, brokers, landlords or the like.
If you manage a property or you sell a rental that produces suspended passive losses, you can typically write off your rental real estate losses. But be prepared to answer any questions the IRS may have if your losses are sizable.
7. Holding Foreign Bank Accounts
There are completely legitimate reasons for having bank accounts in other countries. For example, you might like to travel to Canada to go skiing in the winter. Having a Canadian bank account offers easy transactions.
But it’s important come tax time that you report to the federal government your Canadian bank account exists, especially if it holds more than $10,000.
Failing to report this could trigger hefty fines and criminal penalties up to five years in prison. Before you panic, chances are if you were not aware of this rule, the fed likely will report a “non-willful violation.” Meaning you’ll pay up to $12,459 for each violation.
However, if the fed decides it was willful, you’re in hot water and could face criminal charges and possibly jail time. So, if you open any foreign bank accounts, be sure to report these to the IRS.
Being audited is never fun. If you’re in retirement or approaching it, be sure to pay close attention to these seven tax audit red flags so you can fly under the radar with ease.
To a richer life,
The Rich Life Roadmap Team