Skip to main content
tax trap

5 Common Tax Traps and How to Avoid Them

As a tax consultant I have clients from all walks of life. I work with people just scraping by on social security income, as well as business clients making tens of thousands of dollars per month. But over the years I’ve noticed a pattern of common tax traps that people consistently fall into, regardless of their income. These tax mistakes are so notorious that they deserve special attention.

In this article I explore some of the most common tax traps I’ve noticed while working with clients and how you can easily avoid them.

Tax Trap #1. Account Rollovers and Early Withdrawals

A rollover is simply moving money from one eligible account to another. If you’re not careful however, a rollover can cause a huge tax headache. If you receive a distribution and do not deposit it into another account within 60 days, you will face early withdrawal penalties (10%), interest and income tax on the amount distributed.

Further, certain rollovers are not tax-free. For instance, any rollover from a tax deferred account (i.e. 401K, Traditional IRA, DB Plan) into a post-tax plan (Roth IRA), will create a taxable event. Because tax deferred contributions reduce your taxable income (and Roth IRAs don’t) you will pay taxes on any transfer from these accounts into a Roth IRA.

For more on the Pros and Cons of IRAs, check out: 15 Money Mistakes You Can’t Afford To Make

Tips to Manage an Account Rollover

When rolling over an account, be aware of the possible tax ramifications. Even if you don’t owe taxes, you’ll still receive Form 1099R reflecting the rollover and must report it on Form 5498There are also certain exceptions to the early withdrawal rule, see if you qualify for a hardship withdrawal.

Ways to Roll Over Accounts

  1. Trustee-to-trustee transfer– A transfer between retirement plan administrators; the money never passes through you. Trustee-to-trustee transactions protect you from making mistakes on the transfer.
  2. Direct rollovers & 60-day rollovers– If you receive a payout/distribution from your old plan, request that the check be made payable to your new account. If you have already received a payment in your name, ensure that you deposit the funds into an eligible account within 60 days. You will not be taxed on the transfer but don’t forget to report it!

Tax Trap #2. Estimated Taxes on 1099 Income

A significant number of truck drivers fall into this tax trap and are stuck with huge bills. If your main source of income is reported on Form 1099, you’re a contractor and must pay estimated taxes. Estimated taxes are self-payed, on a monthly or quarterly basis and cover everything that employers would typically withhold for you.

Contractors should also know which states they will owe taxes to. This is largely dependent on where they are doing business.

Tips to Manage Estimated Taxes

  • Refer directly to Form 1040ES  for details, exceptions and a worksheet to help calculate your estimated taxes.
  • Take the total tax you owed last year and divide it by 4. These are you approximate taxes due each quarter. Divide the total tax by 12 for a monthly amount.
  • Set aside your tax withholding money first, then allocate the rest to your expenses.

Tax Trap #3. Your Business Is Deemed a Hobby

When your business is deemed a hobby, even when it was previously profitable, all of your business write offs become disallowed!

If your business has been unprofitable and is not a current source of income, it is unlikely that you have a business as defined by the IRS.

The IRS defines a business [in part] as:

The term trade or business generally includes any activity carried on for the production of income from selling goods or performing services.

If you don’t have business income, be very careful about deducting expenses on Schedule C.  If you’re not sure whether you have a business or a hobby, please refer to the IRS publication on this topic.

Tax Trap #4. You’re Married But Filing Separately

If you’re married there are dozens of reasons to file jointly and only a few good reasons why you should ever file separately.

Some Disadvantages of Filing Separately:

  • If Married Filing Separate (MFS) your tax rate is usually higher than it would be on a joint return.
  • MFS limits your IRA contributions significantly.
  • MFS significantly limits the tax credits you can claim.
  • If MFS your capital loss deduction is cut in half.

There are many more limitations of filing married filing separate. Please see IRS Publication 17 for full details.

Possible Reasons to File Separately:

  • Your partner has a previous tax liability. If you file jointly your refund will apply to the balance owed.
  • Your partner is on a income based debt repayment plan and filing jointly will make current installments too high.
  • You are in the process of divorcing.
  • Jointly filed, combined income interferes with miscellaneous deductions or medical care expenses. These deductions are based on total income and splitting your income may open the door for deducting out-of-pocket medical expenses and casualty losses.

If you’re still wondering the best way to file, one way to be sure is by completing two returns and comparing them.

Tax Trap #5. Leaving Money on the Table

If you’re not claiming every credit you qualify for and not taking every deduction or income adjustment available, you are leaving money on the table. Whenever you have a major tax change, hire a tax pro to do the returns. In the following years you can use software (along with your prior year tax returns) to complete the current year returns yourself.

If you are getting huge refunds each year, congratulations, you’re also leaving money on the table. When you get a big refund it’s because you had too much money withheld from your paycheck. So while you’re giving the government an interest free loan, you have less spending money throughout the year.

Moreover when people receive big refunds they’re much more likely to spend it all at once. Instead, focus on calculating the ideal withholding amount and saving more throughout the year.

What tax traps have you fallen into, and how did you climb out?

2 thoughts on “5 Common Tax Traps and How to Avoid Them

    1. Some might, but I probably wouldn’t!

      I like the public roads, education, health programs, unemployment and labor programs, veterans benefits, food and agriculture programs, housing and community programs, energy and environmental programs, international affairs programs, transportation and science funding parts.

Leave a Reply

Your email address will not be published. Required fields are marked *