It’s not that surprising that there’s a lot of misinformation out there about taxes. The U.S. tax code is over 4 million words long and not one of us has the time to go through it all. Most of us treat the tax code like the monster it is, interfacing with it only from a distance and once a year paying homage to it in the form of a tax return.
Since there’s so much to know about taxes and so little willingness to learn about them, people sometimes make assumptions about how the system works that turn out to be false. These bits of false information sometimes take on a life of their own and, unfortunately, become common knowledge. This is problematic because a misunderstanding of how the tax system works can have consequences — most personal financial planning requires a basic, and reality-based, understanding of how taxes work. Otherwise, you could find yourself owing a lot more money than you expected — or, at least, worrying about irrelevant details when you should be relaxing.
For Americans already spending nearly 24 hours each year filing taxes, there’s no need to add another minute. Here are a couple of common myths and misunderstandings about taxes, and what’s really going on.
1. Myth: you can audit-proof your return
The Treasury Inspector General for Tax Administration, one of America’s tax czars, estimates that taxpayers owe billions of dollars more than what they claim they owe during tax season. Unfortunately for the Internal Revenue Service, they won’t be able to reclaim all of that money. All told, only about 1% of all tax returns filed are audited, a number that could dip even lower as the IRS faces severe budget cuts that will freeze hiring and limit overtime hours in 2015.
Unfortunately for tax filers, there’s no way to ensure that you won’t fall into that 1%. The IRS can, and does, audit people from every income bracket, including those who report no income. In fact, tax professionals are obligated to prepare returns as if they were going to be audited by the IRS, and they are not permitted to make decisions regarding a filing position based on the likelihood that it will be examined. What this means is that tax professionals are bound by sacred oath to not game the audit lottery. They are (technically) not allowed to advise you on the likelihood that your return will be audited based on how you choose to file.
It stands to reason that if the more glaring errors there are with your return, the more likely you are to be audited (or, as the IRS puts it, be subject to “examination.”) However, even if you file a perfect return, there is a chance that you’ll be selected for additional screening. The good news is that most Americans have a very low likelihood of being selected — less than 1% if you earn anywhere between $1 and $200,000 per year. If you earn more than that, the odds of getting a call from the IRS increase.
|Adjusted gross income||Percentage of total returns||Audit rate|
|$1 to $25,000||39.91||1.00|
|$25,001 to $50,000||23.55||0.62|
|$50,001 to $75,000||13.02||0.60|
|$75.001 to $100,000||8.12||0.58|
|$100,001 to $200,000||10.09||0.77|
|$200,001 to $500,000||2.60||2.06|
|$500,001 to $1,000,000||0.41||3.79|
|$1,000,001 to $5,000,000||0.19||9.02|
|$5,000,001 to $10,000,000||0.01||15.98|
|$10,000,001 or more||0.01||24.16|
2. Myth: an audit means scary men in dark glasses at your door
Just mentioning the word “audit” is enough to give some people a headache. Even those who haven’t had to endure one flinch when they hear the word, many of them imagining a litany of phone calls from stern government workers and men in dark glasses rifling through their receipts.
But, believe it or not, the IRS would like to go about its business as unobtrusively as possible. Of the approximately 1.56 million individual income tax returns examined (audited) in fiscal 2013, only 30% were examined in the “field,” as the IRS puts it. The rest were conducted through correspondence.
“Enforcement of the tax laws is an integral component of the IRS’s mission,” wrote the IRS in its 2013 data book. “Some examinations are handled entirely by mail, while others are conducted in a taxpayer’s home, or place of business, or at an IRS office, or office of an attorney, accountant, or enrolled agent.”
Something that is worth noting is that when businesses are audited, they are way more likely to get a visit from a man in dark glasses than not. Of the 28,235 corporation income tax returns examined in fiscal 2013 (1.4% of total corporation tax returns filed), an incredible 92% were examined in the field. That’s less than the 97% that were audited in the field during fiscal 2012, but still a high probability. Another fun, but perhaps self-explanatory, fact: 100% of estate tax returns that are audited are audited in the field.
3. Myth: once I retire, I’m tax free
There are a lot of benefits to retirement, but leaving the workforce and entering your golden years doesn’t necessarily free you from all the bonds of labor. Odds are (unless you buried your life savings in the backyard) you will still have income in retirement, and if the government is good at anything, it’s collecting taxes on income.
The good (bad?) news is that you may fall into a lower tax bracket in retirement, particularly given the sore state of retirement savings in the United States right now (estimates vary, but Americans are running an estimated retirement savings deficit of approximately $4.13 trillion, according to the Employee Benefit Research Institute.) This, though, depends on two things: one, how much of your pre-retirement annual income you expect to live on in retirement — and two, your ability to actually save enough money to make that goal a reality. Many experts suggest that you’ll want at least 70% of your pre-retirement income in retirement to live comfortably.
You can reduce your tax liability in retirement by establishing a Roth IRA instead of a traditional IRA, and paying your taxes upfront rather than when you withdraw. Whatever you do, keep in mind that if you take the miserly route and withdraw as little money as possible from your retirement accounts, you may be subject to required minimum distributions laws come the age of 70.5. You can face tax penalties up to 50% of the amount you withdraw if you fail to take the minimum amount required from your retirement account each year.
4. Myth: corporations write the majority of Uncle Sam’s paycheck
Whether or not individual politicians are bought and paid for by the private sector is a fair question to ask, but Uncle Sam still works for the American people. At least, individual income taxes account for the vast majority of total government receipts.
This fiscal year to date, the government has collected (or withheld) about $514.8 billion from the individual income tax and just $104.5 billion from corporation income taxes. As a share of the $1 trillion receipts collected by the government this fiscal year to date (the government’s fiscal year begins in October), personal income taxes account for 49.2%, while corporation income taxes account for about 10%.
At its peak, in the 1940s and early 1950s when the government imposed war-time taxes on corporate profits, corporation income taxes accounted for about 23% of total government revenue. Corporation income taxes have fallen dramatically over the past 40 years or so from an all time high of 52.9%, even though the Tax Reform Act of 1986 was designed to increase the share of government receipts collected from corporations and decrease the share collected from individuals.