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How to defend yourself during a tax audit

By Anne Dullaghan/GOBankingRates

If you're like most Americans, one of your worst fears during tax season may be having your return audited by the Internal Revenue Service. But what are your chances of being audited? In 2010, unofficial IRS audits resulted in 3.9 million taxpayers receiving notice that they had under-reported their incomes and would be assessed interest and penalties, while 4.7 million people had math errors on their returns that required additional tax payments.

Good record keeping and organized documents are key to protecting yourself in case of an audit. The trick is knowing what to keep, where to keep it and for how long. The Federal Deposit Insurance Corporation (FDIC) has the following tips on how to manage your bank account and other financial records.

Documents you'll need during an audit

Whether you bank online or receive physical bank account statements, be sure to save these important documents:

Credit card and bank account statements. You might only need to save statements with no tax or other significant transactions for a year. A good idea is to download your detailed year-end bank account statements, if available, and keep those rather than multiple monthly statements.

Deposit, ATM, credit card and debit card receipts. Keep your receipts until you see that each transaction is on your bank account statement and is accurate. Past that point, bank account statements are adequate records of transactions.

Payments made by check. You'll want to hang on indefinitely to checks written to pay for a home or its sale, renovations or non-deductible contributions to an individual retirement account. Be sure to download and save any checks you've cut for charitable contributions, tax payments, and alimony and child support payments for at least the last seven years.

Banking and credit card statements aren't the only financial paperwork you might want to keep track of -- depending on your situation, you might want to also keep the following:

Loan agreements. In addition to your home mortgage loan documents, you'll want to indefinitely save other agreements such as second houses, car loans (even if the note is paid off) and personal and business loan documents. The chances of being audited due to these loans are slim. However, you'll want to have them as backup in case you have a loan dispute down the road.

Investment statements. You'll want to save proof of stock and bond purchases, as well as retirement account contributions and withdrawals for at least seven years.

5 tips for smart financial record keeping

It's not enough to simply stash your bank account statements, loan documents and investment statements somewhere. Keeping documents organized and safely filed away will help make the difficult process of being audited simpler -- but you don't want to stockpile unimportant papers that you'll never need, either.

Here are some tips to help you store your important financial records.

1. Stash long-term financial records

Keep federal and state income tax returns and supporting documentation for at least six years. (If you've under-reported your gross income by 25 percent, the IRS has six years to audit you.) It's also a good idea to retain your pay stubs until year-end to compare with the amounts shown on your W-2.

2. Keep active files nearby

You can store bank, mutual fund and other investment-related statements in your home office or in an accordion file. You'll also want to file all your utility, credit card, home maintenance, property tax and other bills in the same easily accessible place.

3. Trash short-term papers

You can throw away old bills once you verify that they're correct; you can also get rid of monthly or quarterly investment statements after you've checked their accuracy.

4. Protect your key documents

Anything that's difficult to replace or involves a financial transaction should be kept in a bank safe deposit box or UL Class 350 fire-resistant home safe. These items include:

  • Adoption records
  • Birth certificates
  • Citizenship papers
  • Divorce decrees
  • Insurance documents
  • Marriage licenses
  • Passports
  • Property records such as deeds, titles, mortgages and other real estate-related documents
  • Records of military service
  • Social Security records
  • Stock, bond and mutual fund certificates
  • Wills

Make a detailed list of your documents, photocopy them and indicate, in your safe deposit box or another place in your home, where they are stored.

5. Invest in a paper shredder

Finally, to prevent identity theft, consider purchasing an inexpensive paper shredder to shred any documents that contain your Social Security number, your bank account, investment or credit card numbers, or other personal information.

Organizing your records, then storing your bank account statements and tax returns takes a bit of time, but it's well worth the effort. In case of an IRS audit, you'll have everything at your fingertips when you need it.

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