Avoid Common Tax Traps

Medical personnel of the Landstuhl Regional Medical Center (LRMC) transports a stretcher bearing injured CBS News correspondent Kimberly Dozier to the LRMC facilities in Landstuhl, Germany, in this photo released by the press office of the LRMC May 30, 2006. Earlier that day, Dozier arrived at the U.S. Air Base in Ramstein and was transported to the LRMC by ambulance.
AP/LRMC/Spc. Christopher Goodman
If you don't pay what you owe in taxes, the IRS will track you down and extract full payment plus a hefty sum in penalties and interest.

But if you pay too much, don't expect Uncle Sam to contact you about a refund. That's why it's important for taxpayers to claim every deduction and tax credit for which they are eligible.

In the second of his three-part "Tax Watch" series, Ray Martin, financial contributor for The Early Show, outlines the traps many taxpayers fall into, such as not claiming a rightfully earned credit.

These credits include:
  • Child tax credit: You may be able to claim a $500 tax credit, which will reduce the taxes you owe or increase your refund by $500, for each child younger than age 17. There are income limits; couples filing jointly who earn more than $110,000 but less than $129,000 can claim only a partial credit. Those who earn more than that can claim no credit at all.
  • Dependent care credit: You may be able to claim a credit of $720 for one child or $1,440 for more than one child to cover child care that enables you to work. You'll need the Social Security number or tax identification information about each caregiver paid, so baby-sitting or home daycare may not qualify.
  • Adoption credit: Parents who incurred expenses to adopt a child may be eligible to take a credit if the youngster has special needs.
  • HOPE Tuition Credit or Lifetime Learning Credit: If you qualify, you may be able to deduct as much as $1,500 for the first two years of college, or for a vocational or trade school. Taxpayers can claim these for themselves and for their children, although there is an income limit of $80,000 for married couples filing jointly or $40,000 for single people.
Since most interest payments are not tax-deductible, many taxpayers might not know that they can deduct up to $1,500 in interest on a qualified student loan.

For the self-employed, some deductions will whittle away the tax burden, including those involving the following:

  • Home office: The IRS has made it easier to take a deduction for using a home as an office. In the past, only money-making activities were allowed for deductions. Now, a home used for necessary and administrative duties also qualifies. Avoid taking this deduction if you plan to sell your home soon because these prior deductions will be applied.
  • Business equipment: The self-employed can deduct up to $19,000 in expenses for furniture, computers and other business supplies and equipment.
  • Retirement plan: Contributions to several plans are deductible. You can deduct up to 20 percent of your net income to a maximum of $30,000 for a Keogh plan; 13 percent up to $24,000 for a SEP IRA, and 100 percent of net self-employment up to $6,000 for a simple IRA. Self-employed taxpayers with net earnings of less than $46,000 might want to invest in a simple IA.
Those who have done a lot of stock trading during the year may want to consult a professional tax preparer because there are some pitfalls to avoid.
  • Consider all costs: When you invest, make sure you add the fee charges and commissions to the cost of the investment.
  • Consider the time frame: When you hold an investment for less than a year, you'll pay the short-term gains rate, which could be as much as 40 percent. If you hold it for more than a year, you will have long-term capital gains rates at 28 percent.
  • Estimate your taxes: Taxes are not withheld from profits when you sell an investment. A lot of online investors will get caught with the tax underpayment penalty. If you don't pay 90 percent of what you owe in taxes with estimated payments throughout the year, there will be penalties at year-end.
One of the biggest traps for taxpayers involves using the IRS as an interest-free savings bank and having to fill out a form to get their money back.

People who are getting huge refunds are better off receiving a larger paycheck now and spending the money - rather than buying on credit - or saving it in an interest-bearing account.