Audits, IRA and More on Lucky the Goose

Dear Readers,
First a correction. In my June 10 column ("A Special Tax Deduction You Don't Want to Miss") I discussed something called "Income in Respect of a Decedent." Based on information provided by one of my sources for this article, I wrote that IRD was subject to the 2% phaseout for itemized deductions. This is not the case. It is, in fact, fully deductible.

My thanks to Scott G. for pointing this out.

This week, I'll tackle a potpourri of questions and letters about tax audits, IRA withdrawals and our friend Lucky the Golden Goose.

Gail --

Does your likelihood of being audited increase with your income level? My wife and I gross $60,000.00 and have an adjusted gross of under $40,000. Do we have a lower chance of being audited that a couple making six figures?

Dear SC,

First of all, relax! Most people are never audited. And, in fact, IRS has been conducting fewer audits in recent years. In 1997, roughly 1.5% of individual tax returns went through this process. Last year, the rate was less that half that: just 0.6% of all returns (731,756) were audited.

A spokesperson for the Internal Revenue Service suggests there is less need for audits because of the increase in the number of returns which are filed electronically, eliminating mathematical errors. Regardless of the rate, it's the "fear factor" of an audit that the government hopes keeps most of us honest. (Here's my May 24 column about audits.)

You're correct that as your income goes up, so does your chance of being audited. But you don't see any significant increase until your income exceeds $100,000. According to the latest IRS data, if your income is between $25,000-$100,000 your chances of being selected are one in 500.

Interestingly, you actually have a higher chance of being audited if your income is under $25,000. The reason according to the IRS, is that folks in this income bracket can qualify for the "Earned Income Tax Credit," a complex calculation. Since it's easy to make a mistake in figuring this, a higher percentage of these returns are checked for accuracy.

Once your income is over $100,000 your odds of being audited jump to 0.7% -- three times the rate of for those in the $25,000 to $100,000 category. That equates to 7 out of every 1,000 filers.

The IRS uses a top-secret formula to determine which returns to audit. Every return is "scored" based on this "Discriminant Function" test. A high "DIF" score kicks out your return for a closer look. Non-IRS sources list a number of factors they claim lead to a higher score.

And, it's not just how much income you report, it's also the source of that income. For instance, self-employed individuals and those who work in "cash" businesses or who receive tips are supposedly prime audit candidates. Obviously, it's tempting for these folks to manipulate the numbers and under-report their actual income.

Unofficial sources say other potential audit triggers include big charitable contributions, tax shelters, and large write-offs for business expenses, such as home office deductions and mileage driven on your personal vehicle.

And, all audits are not created equally. The lowest level of scrutiny is the "correspondence audit" which is simply a letter from the IRS asking you to explain some item on your return. If the questions about your return are more complex, the IRS can bump its investigation up to the level of "office audit," in which you or your tax preparer have to bring documentation to the local IRS office to justify what you reported.

There's also the "field audit" in which the IRS comes to you. This might be done when it's impractical to haul all the requested documentation to the IRS office.

The IRS has a handy reference you can read, order or download from their Web site. It's Publication #556, "Examination of Returns and Appeals Rights."

If the IRS determines that you owe more tax than you paid, it will send you a notice of this, including interest owed. Don't ignore this. Even if you can't afford to pay the full amount, you should contact your local IRS office and work out a payment schedule. In extreme cases, the IRS can garnish your wages and/or file a lien against your property.

Keep in mind that under the law, an audit is a civil process. However, if in the course of its investigation, the IRS uncovers what it believes to be fraud, organized crime or other criminal offenses, your case will be turned over to the Justice Department for prosecution. Remember, Al Capone didn't end up behind bars because the government got the goods on him for racketeering, but for income tax evasion!

Look on the bright side: there's a chance you could have overpaid your taxes. Last year, 4% of the individuals whose returns were audited received a refund.

Let me put it this way, I wouldn't turn down a higher-paying job just because it increased my chances of being audited.

Hope this helps,

Gail

Gail,

I understand from your June 14 column that I can withdraw money from my IRA to pay for personal higher education expenses (tuition) for myself as long as I treat that money as income and pay regular income tax on these withdrawals. However, if I withdraw money for this purpose, am I still allowed to make contributions to my IRA and take the corresponding tax deduction on my next federal income tax return?

Please advise.

Thanks,

Jeff

Dear Jeff,

In a word, yes. Taking a penalty-free withdrawal from your IRA to pay for Qualified Higher Education expenses does not preclude you from making a tax-deductible contribution to your IRA if you are eligible.

Gail

Ms. Buckner,

Greetings from Afghanistan. I read the articles about "Lucky the Golden Goose" laughing to myself as when I was growing up if I had $5 in my pocket it was spent. But I learned my lesson as I grew older, and talked to my daughter about the importance of saving.

I'm happy to say it was not in vain. When my 8-year-old won $100.00 and I asked he what she wanted to do with it she responded, "Duh, savings, Dad".

I was so proud of her I gave her $20 and put the whole $100 in the account. She loves to look at her bank account and although her investments are down she knows it's for the long haul. I will send her the book.

Thanks,

Rick Ivey

Dear Rick --

You bring up two great points:

1. It's never too late to learn, and

2. Our kids absorb more of what they hear from us than we realize.

Our prayers are with you and your comrades in the armed services. Come home safely.

God bless,

Gail

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.