Filing An Extension Buys You Six Months

by Andrew D. Schwartz, CPA

Unable to complete your tax returns by April 15th?  If so, make sure to file Form 4868, Application for Automatic Extension, with the IRS (available at www.irs.gov) by April 17th. 

It's important to note that when you file for an extension, you are asking for more time to finish paperwork, not more time to pay any money that is due. If you owe taxes as of April 15th, expect to pay interest, and possibly a penalty, on the amount due. Whether you're subject to a penalty depends on the amount of taxes owed after April 15^th.  Let's look at the basics:

• Interest:  If you have a balance due to the IRS after April 15th, expect to  be charged interest by the IRS.  The current interest rate is 7%, which is a lot less than the rate charged by most credit card companies.

• Failure to Pay Penalty:  If you file for an extension, and you owe more than 10% of your final tax liability, expect to get hit with a "failure to pay" penalty that runs at 0.5% per month.  That’s in addition to any interest you’ll owe on the balance due.

• Failure to File Penalty:  If you don't file an extension request by April 15th, the "failure to file" penalty runs at 5% per month, up to a maximum of 25% of the taxes owed.

For example, let's say you earn $100,000 this year and have a total federal tax liability of $20,000.  To avoid the 0.5% per month failure to pay penalty, you can't owe more than $2,000 when you file a tax return later this year.  By having 90% of your  total tax liability paid by April 15th, filing an extension provides for an extra six months to come up with the remaining tax dollars owed at a relatively low interest rate. 

What if you didn't bother to file for an extension?  Unless you can show the IRS "reasonable cause", expect to be assessed the failure to file penalty of $100 per month on a $2,000 balance due.

Extensions Can Make Sense For Self-Employed Individuals

If you're self-employed, you might benefit by filing for an extension even if you can complete your tax returns by April 15th.  That's because you have until the due date of your tax return, including extensions, to fund your retirement accounts for the year.  Even if you don't have a retirement plan set up yet, a SEP IRA can be established as late as the extended due date of your return, or October 15, 2006.

By filing a Form 4868 with the IRS, you get an additional six months to fund your retirement plan and deduct the contribution made on your prior year's return.  One strategy common to self-employed individuals is to pay the full amount of taxes due with an extension, and then to fund their retirement plans prior to October 15th.

Keep in mind that an extension does not give you any more time to fund your Roth IRAs, traditional IRAs, and Coverdell Education Savings Accounts (ESAs) for 2005.  The due date for these tax-advantaged retirement plans and college savings accounts is April 17^th.

Does An Extension Increase The Chances of An Audit?

I have clients who are convinced that filing for an extension is a red flag with the IRS.  And I have others who always file for an extension because they've heard that they're less likely to be audited by doing so.  Personally, I've never seen any connection.

Can’t Pay Your Taxes By April 15th?

What if you need more time to pay your taxes?  If you owe so much taxes that you won’t be able to pay them off by October 15th, one option is to file the paperwork to enter into an installment arrangement with the IRS. This is done by completing and filing a Form 9465, and attaching the completed Form 9465 to the front of your federal income tax return. On this installment request form, you tell the IRS how much you can afford to pay each month and the day of the month that the payment will be made. 

The IRS charges a fee of $43 to any taxpayer who enters into an installment arrangement. In addition, the IRS will charge interest at the prevailing federal rate (currently 7% per year), and a "failure to pay" penalty of 0.25% per month on the outstanding balance. Plus, failure to make a scheduled payment will cause the remaining outstanding balance to become immediately due.  And you generally aren't allowed to enter into an installment agreement if you have an open installment agreement for a previous year that hasn't been paid off yet.

Always Submit Your Paperwork On Time

The moral of this story is simple.  Since the failure to pay penalty is so much smaller that the failure to file penalty, always try to file all your tax returns and extension requests on a timely basis, even if you're unable to pay the full amount of the taxes due at that time.

TOP

Moonlighters May Face High Tax Bill on April 15

by Andrew D. Schwartz, CPA

As April 15th looms, it is important for taxpayers who “moonlight” to distinguish whether they are compensated as an employee or independent contractor. Whether you moonlight to supplement your salary, pay down your student loans, or build a nest egg, how you're compensated determines how you will be taxed.

If you haven’t completed your taxes for 2005 and aren’t sure how you were compensated last year, you could be facing a large tax bill on April 15th. If taxes are withheld from your pay, you're considered an employee. No taxes withheld means you're an independent contractor.

Generally, each employer has a set policy as to whether they compensate their moonlighters as employees or as independent contractors. Here are some of the advantages and disadvantages to being compensated as an independent contractor:

Advantages

• Professional expenses can be deducted directly against income. Let's say that you earn $10,000 moonlighting as an independent contractor, and have $6,000 of un-reimbursed professional expenses to deduct against that income. In this example, you'll pay taxes on only $4,000 of net moonlighting income. If you were paid as an employee instead, you would claim your professional expenses as an itemized deduction subject to various limitations and the Alternative Minimum Tax (AMT).

• As an independent contractor, you can establish and contribute money into a pre-tax retirement account based on your net moonlighting income. Individuals have until April 17, 2006 to set up and fund a SEP IRA for 2005 (or October 15 for those filing for an extension), and sock away up to 20% of their net moonlighting income. Amounts contributed reduce your taxable income and grow tax-deferred. Other pre-tax savings opportunities available to independent contractors include SIMPLE IRAs and Solo 401(k) plans.

• 100% of health insurance premiums can be deducted. As long as you are not covered under an employer sponsored health insurance plan, being paid as an independent contractor allows you to write-off your health insurance premiums paid during the year.

Disadvantages:

• Independent contractors are subject to an additional tax known as the "self-employment tax". When someone works as an employee, their employer withholds social security and Medicare taxes from their pay at a rate of 7.65%, and then matches the taxes withheld. So the government gets 15.3 cents for every dollar earned. When a person is self-employed, they are required to report and pay that 15.3% tax, known as the self-employment tax, as part of their federal tax return. The self-employment tax rate goes down to 2.9% once a person’s combined salary and net moonlighting income exceeds $90,000 for 2005 and $94,200 in 2006.

• An independent contractor's tax return becomes much more complicated. The days of preparing the 1040-EZ are over. You now need to complete and send in the long form, along with a Schedule C, Schedule SE, and whatever other tax forms and schedules might be required.

• Independent contractors may be required to prepare and submit quarterly estimates. The government generally doesn't allow you to write them a big check on April 15th. Depending on how much you earn moonlighting and what else she has going on with your taxes, you might need to remit quarterly tax payments to the IRS to keep from getting penalized. A 1040-ES form should be used to remit federal estimated tax payments.

Monitor Your Withholdings

Even if taxes are being withheld from a your moonlighting income, don't assume that enough taxes are being taken out. That's because each employer withholds taxes as if they are the only employer.

For example, if your earn $20,000 from three employers during the year, the amount of federal income taxes withheld from your pay will be significantly less than if you had earned $60,000 from just one employer.

To make matters worse, if you tell your employer you are married, they will start withholding even less taxes, since the withholding tables for a married person assume your spouse doesn't work.

The 40% Rule

Moonlighters who are paid as independent contractors have no taxes withheld. In that case, it's generally a good idea to set aside 40% of earnings for taxes. Don't forget, you'll owe federal taxes, state taxes, and self-employment taxes on your net moonlighting earnings.

Plan Ahead

The taxes you'll owe on your moonlighting income are manageable if you plan ahead. Don't let the possibility of a surprisingly large tax bill deter you from taking advantage of moonlighting or consulting opportunities that may arise.

TOP

TAX AND FINANCIAL PLANNING CALENDAR FOR APRIL 2006

TOP

2005 & 2006 TAX FACTS

• For 2005, the standard deduction for a single individual is $5,000 and for a married couple is $10,000. A person will benefit by itemizing once allowable deductions exceed the applicable standard deduction. Itemized deductions include state and local income taxes (or sales taxes), real estate taxes, mortgage interest, charitable contributions, and unreimbursed employee business expenses.
• For 2005, the personal exemption is $3,200. Individuals will claim a personal deduction for themselves, their spouse, and their dependents. 
  
• The maximum earnings subject to social security taxes is $94,200 for 2006, up from $90,000 in 2005.
  
• The standard mileage rate is $.485 per business mile as of September 1, 2005 (after being $.405 per mile through August 31, 2005), and will then be $.445 per mile for 2006.
  
• The maximum annual contribution into a 401(k) plan or a 403(b) plan is $15,000 for 2006.  And if you'll be 50 or older by December 31, 2006, you can contribute an extra $5,000 into your 401(k) or 403(b) account this year.
• The maximum annual contribution to your IRA is $4,000 for 2005 and 2006.  And once you turn 50, you can contribute an extra $500 into your IRA for 2005 and an extra $1,000 for 2006.  You have until April 15, 2006 to make your 2005 IRA contributions. 

TOP

copyright - 2006 - CPANiche, LLC