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4 Expensive Penalties that Taxpayers can Easily Avoid

Monday, April 18, 2011

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Over the years, Congress has dreamed up lots of penalties to punish tax scofflaws. Here are four expensive penalties that taxpayers can easily avoid:

Tax penalties
The 5% Per Month Failure-to-File Penalty
When you fail to file your Form 1040 by the deadline, you will be charged 5% per month, based on the unpaid balance of what you owe, until you send in your return. The maximum penalty is limited to 25% of the unpaid balance. So after five months, the penalty doesn't get any bigger, but you'll still be charged interest until you pay up.

The good news is the failure-to-file penalty is easy to avoid. The secret is to either file your return this year by the April 18 deadline or to extend it by that date (using Form 4868). If you extend, you can put off filing your Form 1040 until as late as October 17.

Here's the most important thing to know: You don't actually have to pay your tax bill when you file or extend. Since many cash-strapped folks wrongly believe you must pay right away, they wind up not filing or extending. So they get hammered with the failure-to-file penalty, which only makes things worse.

If you can't pay by the April 18 deadline, you can usually arrange with the IRS to pay the shortfall in installments over as many as 60 months. You'll be charged interest on the unpaid balance, but the current monthly rate is only .583% (the rate can change each quarter). Alternatively, you could put your tax bill on a credit card if you think that's a better deal.

Whatever you do, don't blow off filing your return. That would be an expensive and completely unforced error. Be smart: File or extend by the April 18 deadline.

The 20% Intentional Disregard Penalty
Say you get audited and the IRS decides your tax return understates your tax bill because you intentionally ignored applicable rules and regulations. Watch out! You will be hit with a penalty equal to 20% of the understatement. Plus you will be charged interest. Ouch! The sad truth is our tax system is so complicated you can conceivably get hit with this penalty without knowingly doing anything wrong.

The solution is to hire a tax pro when you know (or suspect) you are in over your head. If you tell your tax pro the truth and provide him or her with any requested information, you can blame any tax understatement on the pro and successfully avoid the intentional disregard penalty. (Your pro might get penalized, but that's not your problem.)

The 50% Penalty for Failure to Take Retirement Account Minimum Distributions
Once you turn 70½, you must begin taking required minimum withdrawals from any tax-deferred retirement accounts set up in your name -- such as traditional IRAs and 401(k) accounts. (Roth IRAs set up in your name are exempt from these rules for as long as you live.) You must take the first required withdrawal by no later than April 1 of the year after the year you turn 70½(that deadline is rapidly approaching if you turned 70½ last year). Then you must take another required withdrawal by each December 31. If you don't take out at least the required amount, you can be hit with a 50% penalty on the shortfall (the difference between what you should have withdrawn and what you actually took out, if anything). That's one of the most expensive penalties in our beloved Internal Revenue Code.

If you inherit a tax-favored retirement account (including a Roth IRA), you must start taking annual required withdrawals under a special set of rules for inherited accounts. If you don't take out at least the required amount each year, you too can be hit with a 50% penalty on the shortfall.

The 75% Fraud Penalty (Plus Possible Prison Time)
If you get audited, and the IRS decides your tax return fraudulently understates your tax bill, you are in really big trouble. You will be hit with a penalty equal to 75% of the understatement. Plus you will be charged interest. And you could face criminal charges and possible prison time.

Committing tax fraud takes some work, because it goes beyond simple ignorance of the tax rules and regulations. You have to do really bad things like keep two sets of books, alter or destroy documents, hide unreported income overseas, or fail to report income from illegal activities (this is not a complete list by any stretch). Bottom line: You can't commit tax fraud without knowing it.

Anyone accused of tax fraud should hire an attorney who specializes in big-time IRS problems. A CPA or Enrolled Agent can't provide the equivalent of the attorney-client privilege, and those accused of tax fraud will need that privilege. Also, non-attorneys are not competent to deal with the criminal charges that will often go along for the ride with tax fraud cases. (Source)
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