You may have heard them from your neighbor, discussed them at the office or argued over them with your friends. Yes, as we approach tax season, tax myths abound -- and that includes myths pertaining to tax refunds: A large refund is a good refund; I can't be audited if I've gotten a refund, to name just two.
So how do tax myths get started, anyway? One explanation might be our tax system itself, which isn't exactly simple. There are earned income credits, education credits, health savings, Roth retirement accounts, different tax rates on dividends, temporary tax cuts and a multitude of tax brackets. The Internal Revenue Code runs more than 3 million words and the instructions for the 1040 form alone take up more than 100 pages [source: Williams].
Since it's difficult to understand our complex, ever-changing tax system, many half-truths and misunderstandings are born. Read on to learn about some of the myths related to tax refunds and some of the realities.
Think again. All a refund means is that the Internal Revenue Service (IRS) has reviewed your tax return and agreed with your calculations. Deciding who to audit is another matter and is determined long after your refund check is received.
Here's how they decide if you're one of the "lucky" ones: After your refund is paid (assuming one is due), the IRS sends your return through a computer check that compares it to a computer model. It's then given a DIF (Discrimination Information Function) score. The formula for calculating the DIF score is closely guarded by the IRS, but is based on factors such as, for example, the average amount of charitable deductions claimed by a person earning the same salary as yours. If your return receives a high score, an agent reviews it. Those with the greatest potential of yielding more taxes, interest or penalties are audited [source: Lewis].
Although the audit process generally begins three to four months after the filing deadline, the IRS can audit a return up to three years after it is received. But don't' worry too much. Your chances of being audited are slim. If you make less than $25,000, you have less than a 1 percent chance of being audited; if you make more than $100,000, your chances are still less than 2 percent [source: Lewis].
Of course you'd rather receive a check than write one. But letting the government use your hard-earned dollars interest-free, just so you can receive a big refund, isn't really a wise financial decision.
Your optimal objective should be to regulate your withholding exemptions, and thus the amount of tax you pay during the year, so you stay more or less even with the government. You don't want to owe a lot or suffer a penalty for not paying enough of your tax obligation. On the other hand, a huge refund check is a sign that you paid too much over the year. You'd have been better off putting that extra money in a savings account where it could earn some interest.
By diligently putting a little away each month, you'd have something extra to remodel your kitchen, take a fantastic vacation or even pay off bills on your schedule rather than the IRS's. And if you did end up owing the IRS some funds, you'd have some money socked away to handle that.
To change your withholdings, simply complete a new W-4 form for your employer.
Directing your refund to pay off a loan is not an option available to taxpayers. Current IRS procedures only allow you to deposit your refund into a checking or savings account. This can be an individual or a joint account you have with your spouse. You can also opt to have the IRS send you a check by mail or use your refund to buy U.S. savings bonds.
You may even choose to do a split refund. That means you can direct some of your refund to your checking account to use now and some to your savings account for that rainy day. Your tax refund can be deposited in up to three accounts at the same or multiple financial institutions. Each deposit must be at least $1.00. You also can split your refund between direct deposit and a paper check [source: IRS].
It seems that a lot of people think this one is true. In 2010, the IRS announced that 1.4 million people, who were due a refund, still hadn't filed their income-tax return for the 2006 tax year. The IRS was trying to deliver the $1.3 billion in refunds that these people were owed. That's a medium unclaimed refund amount of $604 [source: Herman].
The law allows most taxpayers three years to file a return to claim their refund. If no return is filed, the money belongs to the U.S. Treasury.
While there are no penalties for filing a late return that qualifies for a refund, you're required to bring your filings up to date. Taxpayers seeking a past due refund will find that their check will be held if they haven't filed their more recent returns as well [source: Herman].
Although electronic filing is one of the fastest ways to get your refund, many people shy away from it due to unfounded myths. They think it's a ploy for the IRS to track them down or to investigate their bank accounts.
This is all nonsense. The IRS can find you with or without the electronic filing. And it's not a way for them to snoop through your checking or savings account. The only access the IRS has to your account is to process your refund. Electronic filing is simply a way to save time, eliminate paper cost and speed up the refund process to about 10 days. In fact, the error rate for filing electronically is just 1 percent compared with 20 percent for paper filing [source: CalCPA Foundation]. The IRS estimates that about 70 percent of taxpayers filed electronically in 2010.
Taxpayers beware! The IRS never initiates taxpayer communications through e-mail. So, if you receive an unsolicited e-mail appearing to be from the IRS, it may be part of a phishing scheme. Phishing is a technique used to obtain personal information from unsuspecting people, using an e-mail message that appears to be from a legitimate business. The message attempts to get the recipient to divulge personal data such as account numbers, passwords, credit card numbers and Social Security numbers. Their purpose is identity theft.
What do you do if you receive an e-mail claiming to be from the IRS? First of all, do not reply. Don't open any attachments or click on any links. Forward the e-mail as is to firstname.lastname@example.org. After you forward the message, be sure to delete the original message you received [source: IRS].
This myth may have started with a misinterpretation of a statement made by President Obama in his weekly radio address on Sept. 5, 2009 [source: Snopes]. He introduced the option of receiving your tax refund as a U.S. savings bond. But that is what it is -- an option. The choice of whether you want to buy U.S. savings bonds with your refund or not is yours.
But if you're looking for a way to increase your savings, the savings bond tax refund option might be a good place to start. The U.S. Series I Savings Bonds are low-risk bonds that grow in value for up to 30 years. You can use your tax refund to purchase the savings bonds in increments of $50, up to $5,000. You can use your entire refund or just part of it, and have the rest sent to you as a check or direct deposit.
Series I Savings Bonds earn a composite rate of interest consisting of a fixed interest rate and an inflation-based rate that is adjusted twice a year. The interest you earn on the bonds is subject to federal tax when the bonds are redeemed, but it isn't taxable at the state or local level.
You may not always get all the tax refund you calculated on your tax return. There are several reasons your refund check might be smaller or possibly larger than you expect.
First, the obvious: If the IRS finds a math error or other mistake on your return it will correct the amount of your refund. The IRS also will deduct certain past due amounts you may owe, such as federal and state taxes, student loan payments or child support, and apply your refund to what is owed. If these adjustments are made, the IRS will send you a letter of explanation. You'll also receive a letter from the Department of Treasury's Financial Management Service indicating where your refund money is being redirected [source: IRS].
Refund anticipation loans (RAL) are a fast way -- but not a great way -- to get your tax refund. A RAL is an interest-bearing short-term loan provided most often by a tax preparation company. It's based on the taxpayer's expected refund and subject to fees set by the lender. Some taxpayers choose the loans because they can receive their money in a few days rather than weeks. Plus, several larger tax preparation companies offer the convenience of getting your refund on a debit card. What could be better?
But oh, the price of impatience! You might find yourself paying tax preparation fees, account fees and finance charges on your loan. There might also be fees associated with the debit card, such as charges for ATM withdrawals and balance inquiries. One major company disclosed an annual percentage rate of 264 percent on the refund anticipation loans they offer [source: Bell].
The IRS mandates that taxpayers be advised that a RAL is actually an interest-bearing loan that must be repaid. Providers have to disclose all costs and fees associated with these loans. And to lessen the ease of offering these RALs, the IRS is no longing providing tax preparers with the debt indicator that lets them know if the taxpayer's refund might be lessened for outstanding debts [source: IRS].
All in all, if you want to enjoy your full tax refund, it's better to file electronically and have the money directly deposited into your bank account. You'll have your money almost as fast as with a refund anticipation loan, but without all those fees and interest.
In spite of what your friends might tell you, the peel-off label on your tax return instruction book doesn't contain personal information about you or details about the suspicious deductions you claimed on last year's return. It isn't a way to trace your return and it doesn't red flag your return for an IRS audit.
What the label does contain is coding information regarding mail routes and the forms you used in the past. Failure to use the envelope or label the IRS provides will only delay your return. As innocent as it may sound, the purpose of the label is actually just to speed up your refund [source: Payne].
These are just some of the refund myths you might hear this tax season. While you also might receive some good advice from your friends and associates, double-check anything they tell you and don't believe everything you hear.
The IRS or Internal Revenue Service handles taxes. Learn about the history of the IRS and how it enforces taxes.
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