How My Audit Fears Dictate Our Taxes

Every time we write a post that’s focused on how emotions affect how we handle our money, we get a few comments to the effect of “Why don’t you just look at the math?” To those of you who write (or think about saying) things like that, we admire you. We admire your ability to keep emotion out of it. But we’re just not wired that way. Money carries a lot of meaning to us, and virtually every money subject comes loaded with memories and baggage. Though we’re good at looking at the rational side of our finances, and are perfectly capable in the math department, we try to stay in tune with what our guts are telling us too.

When we feel the urge to shop, we now know to ask ourselves what stress we’re trying to cope with, or what void we’re trying to fill. When we (okay, I) start checking our investment balances too often, I now know that that’s a sign I’m feeling anxious about our plan, or am coping with the loss of control that comes with building our accounts up to a size where the markets have all the say. But there are lots of ways emotions and money are tied up for us. Like with our taxes.

Bearing the Scars of Audits Past

I have a super visceral memory related to taxes that I still carry around with me. My parents divorced when I was in high school. The divorce itself was fine, but what was not fine was watching them get audited post-divorce for a year in which they had been married. It was the worst I ever saw of my parents, but it was also an important lesson in dealing with accountants and the IRS.

I learned that the IRS does not give the benefit of the doubt. I learned that accountants aren’t liable (or at least my parents’ accountant wasn’t liable in their case), even if they make mistakes or exercise bad judgment in how to report something. I learned that their experience is not something I ever hope to repeat.

I do our taxes, but we discuss everything about them. And a few years ago, we realized that we had crossed into a higher audit risk category, based purely on income — for most people, the risk is about 1 audit in 119 returns, but we found ourselves in the 1 in 38 category, about three times higher risk. The very thought of being in a higher audit risk category was enough to make me lose sleep at night, so I set out to learn what we could do to lower our risk. Sadly, short of decreasing our income, there’s nothing we can do to reduce the base risk: the IRS randomly chooses a certain percent of returns every year to scrutinize, and higher income brackets get more of those audits. But there are things, mainly certain deductions, that serve as audit red flags, and raise your risk a lot.

The biggest one that pertains to us: the home office deduction.

We both work 100 percent from home, and have dedicated home office space that we don’t use for anything else but work. The offices are even self-contained spaces, making the square footage and percentage of our house calculation simple. TurboTax would be able to figure out our deduction in a matter of seconds. We have textbook grounds for claiming the home office deduction. But, as you’ve probably guessed, we don’t claim it. It’s simply not worth the risk to us. So many people abuse this deduction that the IRS audits a higher percentage of returns that claim it, and we have no desire to be on that list. (Note: the IRS has simplified the record-keeping rules for claiming the home office deduction, but using the space exclusively for work is still required.)

We do claim all of our charitable donations, so long as we have receipts, though we notice that the AMT starts kicking in after we’ve entered enough of them, and begins to offset the deduction anyway. And we do claim all of the documented expenses on our rental property, since that’s a separate schedule on which all the calculations are made together, and it just spits out one taxable income figure. We also claim our mortgage interest deduction, since we get an IRS form for it, and can’t ignore that, and we max our 401(k)s, which reduces our taxable income. But beyond those things, we don’t go looking for any extra deductions to reduce our tax bill.

The Philosophical Perspective

Knowing that we’ll be receiving a hefty subsidy for our ACA health insurance after we retire, there’s some aspect of this that we see as paying it forward. We’re going to be benefiting from taxes that others pay for many years, so we think it’s only fair that we overpay a little bit now (in addition to the hefty sum that we already pay by virtue of having two six figure incomes).

But we also believe generally in paying our fair share, and think far too many high net worth people pay too little in taxes. (Don’t take our word for it, take Warren Buffett’s.) I wonder from time to time how much of my belief that it’s good to pay our fair share comes from a philosophical place, and how much of it comes from a deathly fear of tax audits. Fortunately, though, Mr. ONL shares my view on paying taxes, so it doesn’t matter why I believe what I believe, only that we agree in our approach.

Looking Toward Future Tax Returns

After we quit our jobs, our income will plummet, putting us in a super low tax bracket. We’ll also lose our mortgage interest deduction because our house will be paid off. We’ll still have deductions from our rental property and charitable contributions and the opportunity to contribute to IRAs, which we’ve been priced out of for a while. But we’ll certainly be back in the realm of the standard deduction, which will make most potential deductions irrelevant anyway.

It will be interesting to see how it feels when we’re no longer paying what feels like our fair share. We’ll still be paying certain taxes, like gas taxes that pay for road repairs and construction, property tax and all the bonds tacked onto that bill that pay for schools and local services, and sales taxes when we buy things. But our income tax – and our audit risk – will go way, way down. On a basic financial level, this is fantastic news. And in terms of my fear of audits, it’s pretty much the best news ever. But will we feel like, in the words of Mr. Groovy, teat-sucking layabouts? We’ll let you know. ;-)

Do emotions play a role in how you do your taxes, or do you go by the book? Anyone else out there avoid certain deductions or exemptions to reduce your audit risk? Think we’re idiots for giving extra money to the federal government? ;-) Have you found any other ways that emotions impact how you manage your finances that you only recently became aware of? We’d love to hear from you!