Worried about the IRS auditing you? It’s rare, but it does happen.
So, don’t breathe a sigh of relief just yet. Certain financial situations can draw extra scrutiny from the federal government. Following are some red flags that could trigger an audit.
This doesn’t mean you should try to avoid all of the following scenarios. But it probably behooves you to keep the best documentation you can, just in case trouble comes calling.
1. Failing to report income (or misreporting income)
Don’t overlook any source of income when filing your taxes. If you get a tax form — whether it’s a W-2, a 1099 or something else — that information also is sent to the IRS.
If that income doesn’t show up on your return, or is listed in the wrong amount, the IRS might automatically flag your return. The agency probably will wonder what other oversights you made.
2. High deductions
The IRS is transparent about how it picks taxpayers to audit. In some cases, you might be chosen because you worked with others — such as business partners or investors — who are being audited. And some audits come from an algorithm that compares your return with everybody else’s. The agency explains:
“Sometimes returns are selected based solely on a statistical formula. We compare your tax return against “norms” for similar returns. We develop these “norms” from audits of a statistically valid random sample of returns.”
In other words, Uncle Sam knows lots of people like you, and he knows what kinds of deductions they tend to take.
Anything unusual about your return — even if it’s completely legitimate — will stick out like a sore thumb. That includes abnormal deductions for charity, medical expenses and business expenses.
3. Not taking your RMD
When you hit age 70 ½, the federal government typically requires you to start drawing a minimum amount from certain types of retirement plans.
This is called a required minimum distribution, and if you don’t take it, you owe a penalty. Fail to take out the RMD by the deadline, and you will owe a 50% tax on the amount not withdrawn.
The IRS knows your age, and missing this deadline will put you on the agency’s radar.
4. Making early retirement withdrawals
Doing the opposite — taking retirement money early, instead of late — can also draw Uncle Sam’s attention.
While the penalty is not as severe as a late withdrawal, you’ll still need to adjust your tax return accordingly. In addition to owing regular taxes on the money, there is a 10% tax on withdrawals made before age 59 ½, unless you qualify for an exception.
5. Reporting big losses
Reporting losses to the IRS can help you at tax time, but only if you’re also honest about wins.
Take gambling, for instance. You’re supposed to report winnings as income, and you can claim losses up to the amount of the winnings you’ve claimed as income as an itemized deduction. If you report losses without mentioning you won anything, don’t expect the IRS to take your word for it.
Similarly, a lot of people have a hobby they envision turning into a full-fledged business someday. But as long as it remains merely a hobby, don’t be tempted to claim your spending on it as business expenses. The IRS is unlikely to believe you’re operating a business that always loses money, especially if you have other sources of income.
Generally, if you fail to report a profit in three of the last five years, the IRS will consider the activity recreational and might have some questions for you about it.
6. Holding foreign bank accounts
If you’ve decided to spend more time abroad in retirement, you could have a legitimate need for a bank account in another country. But it’s important to report that account to the federal government — even if the account doesn’t generate taxable income.
Failing to do so could trigger something worse than an audit. If the feds conclude it was merely a “non-willful violation,” you’ll get off light with a penalty topping out at $12,459 for each violation.
But if they decide it was willful, you could face fines — of up to $124,588 or 50% of the account balance at the time of the violation — and/or criminal penalties of up to five years in prison.