5 Tax Myths That Can Cost You

Rob Berger for Credit.com writes:  Tax myths are a lot like a bad date. They are annoying and seem to last forever. Yet people have beliefs about income taxes that have no basis in reality. Were it not for the potential financial costs, some of these might be amusing. But if you believe them and act upon them, they can cost you serious money.

Tax myths persist for several reasons, including:

• The tax code is extremely complicated, and therefore misunderstood;
• Revisions have changed the code, but old ideas live on long afterward; and
• News media stories make the rounds, and endure even if they aren’t entirely accurate.

When it comes to preparing your income taxes, it’s important to research significant provisions required to file your return. If you’re unsure, you should seek professional help in the preparation of your returns.

Here are some of the more common tax myths that continue to circulate, despite information to the contrary.

1. The Home Office Deduction Is an Automatic Audit

This myth has been around for about a quarter-century and is accepted as gospel among those who are not intimately familiar with income tax preparation. In truth, as long as a home office deduction follows IRS rules, and is not excessive, this deduction is not an automatic red flag for audits.

The IRS has three basic rules when it comes to the home office deduction:

• Regular and exclusive use – This means that the home office is regularly used for business, and has no other use. As long as you have a room in your home that you are using exclusively for business on a regular basis, you meet this requirement.
• Principal place of business - The home office can’t simply be a space that you occasionally use to conduct business. It must be the primary office from which you run your business. This means that you can’t deduct expenses for a principal office outside of your home, in addition to your home office.
• Additional tests for employee use – As an employee, you may be able to take a home office deduction if you a) meet the two tests above, b) your business use of your home is for the convenience of your employer, and c) your employer does not pay rent for the space.

The expenses that you are deducting for the business use of your home must also be reasonable. That means that your deductions should not exceed the amount of square footage of your home office, divided by the total square footage of your home. For example, if your home is 2,500 square feet, and your office is 200 square feet, then you will be able to deduct 8% of your home expenses (200 divided by 2,500) for income tax purposes.

If you deduct 40% or 50% of your total expenses as home office expenses, that could lead to trouble.

For more information on the home office deduction, see IRS Publication 587, Business Use of Your Home.

2. Students Don’t Have to File Income Tax Returns

There are those who believe that your status as a student exempts you from having to file income taxes. But there is no such status in the tax code. The determination for whether or not you need to file a return is determined by the amount of income that you earn for the year.

For 2014, you must file an income tax return if you earned at least $10,150, even if you were a full-time student for the entire year.

There are also situations where you will want to file a tax return even if you made less. One example is if you had tax withheld, and you have no tax liability. You’ll want to file in order to claim your refund.

3. You Must File Jointly If You’re Married

This myth probably exists because it seems to make so much sense. That thought may be reinforced by the fact that in the great majority of instances, the alternative results in higher tax bills. There is no requirement to file jointly, however, simply because you are married. And sometimes the alternative actually does work in your favor.

Even if you’re married, you still have the option to file separately. In about 90% of the cases, married filing joint will work better. But you could very well be in the 10% for whom filing separately is the better option.

Married filing separate can result in a lower tax liability in the event one spouse has significantly higher deductions than the other. When you file jointly, you may lose deductibility of certain items.

Medical expenses are an excellent example. Since they can only be deducted to the extent that they exceed 10% of your adjusted gross income (AGI), lowering the dollar amount of that percentage is one way to increase the deduction.

A couple earning $200,000 and having $20,000 in medical expenses will not be able to deduct any of it since it does not exceed 10% of their combined income. But if the spouse who incurred medical expenses made only $50,000, the 10% limit will be only $5,000.

By filing separately, the couple would be able to deduct the medical expenses, representing a substantial reduction in taxable income. Fortunately, there are computerized tax software packages that can do a joint versus separate filing comparison.

4. You Need a Bank Account to Get a Direct Deposit of Your Refund

This is one of the biggest tax-related myths. While it’s true that the vast majority of refunds do go to bank accounts, it’s not an absolute requirement. For example, you can have your refund sent to most prepaid debit cards, which is one of the refund options the IRS provides.

One of the potential downsides of using prepaid debit cards is cost. There are, however, some prepaid cards that have lower costs. Be sure to do your research before you sign up for one.

5. Getting a Large Tax Refund Is Good Tax Planning

There’s no question, getting a large tax refund feels good. But it doesn’t necessarily indicate good tax planning. For example, if your refund is $5,000, you have to consider that you will have given the government an interest-free loan for that amount during the course of the year. If there was something better that you could’ve done with the money (and there always is), your refund could end up having cost you money.

For example, let’s say that you had a credit card with a $5,000 balance, and an interest rate of 20%. Had you allocated the extra withholding to paying off the credit card, you would have saved yourself upwards of $1,000 in interest charges during the course of the year. It’s a bit more complicated than that, but the example still stands. Any time you’re giving the government use of your money, you are denying yourself the ability to use it for more productive purposes.

True good tax planning is when your refund comes in at a number very close to zero. To achieve that goal, the IRS offers a free withholdings calculator to help you determine how much your employer should withhold from your paychecks.