Personal Income Tax Guide: Documentation And Records
  1. Personal Income Tax Guide: Introduction
  2. Personal Income Tax Guide: Basic Concepts
  3. Personal Income Tax Guide: Documentation And Records
  4. Personal Income Tax Guide: Moves To Make Before December 31
  5. Personal Income Tax Guide: Moves To Make Before April 15
  6. Personal Income Tax Guide: 6 Overlooked Deductions And Credits
  7. Personal Income Tax Guide: Common Filing Mistakes
  8. Personal Income Tax Guide: Avoiding Nasty Surprises
  9. Personal Income Tax Guide: Conclusion

Personal Income Tax Guide: Documentation And Records

By Ken Clark

If "location, location, location" is the most important rule in real estate, then "documentation, documentation, documentation" is by far the most important rule in taxes. Without a system for properly documenting your income and expenses, you're flying blind and without a safety net. To get ready now for tax time, you'll want to review (or create, as the case may be) your tax documentation system.

The Hazards of Poor Documentation
The biggest risk of not keeping accurate and detailed records is that you're likely going to miss opportunities to deduct legitimate expenses. Considering that an average American might make hundreds of deductible purchases each year, there's no way they'll all make it on to your return unless you've documented them somehow. In the end, tracking these expenses in an organized fashion takes far less work than filing an amended tax return when you remember a large expense after you've already filed.

A secondary, but very valid risk, is that you won't be able to back up your expenses if you get audited. Since the basic stance of most IRS auditors is, "if you can't document your expense, then it didn't happen," a failure to keep clear and concrete records can result in significant back-taxes. (For more on this, see Surviving The IRS Audit.)

Lastly, poor documentation is likely to increase the amount of time, money and stress that goes into preparing your tax return. In part, this is because most legitimate accountants will not prepare returns with large amounts of undocumented expenses, requiring you to either go digging for receipts or skip the deduction. Even if you do have documentation, but spend a few hours sorting through it in front of your preparer, you're likely going to get charged for their time. If you're preparing your return yourself, poor documentation can leave your dining room table buried under an avalanche of paperwork, making an already confusing process that much harder.

Creating a System That Works
Before you head off the office supply store to buy a filing cabinet and a few hundred folders, consider something simpler. All you really need is a couple standard size cardboard file boxes and a 10-20 full size document envelopes (with metal clasps). You'll label and use these envelopes to sort your receipts into the major deduction categories used on your return, such as:

  • Income - Use this envelope for all your pay stubs, various 1099s, and statements for your business if you own one.

  • Mortgage/Home - If you own your home, you'll want to put your mortgage statements and Form-1098 in this envelope. You'll also want to include any paperwork relating to home improvements, remodeling, or home equity lines of credit. If you rent a home and live in a state such as California, which gives a deduction or credit to renters, you'll want to include copies of receipts or your canceled checks if available.

  • Utilities - If you use a portion of your home as an office of any kind, you may qualify for the home office deduction. For those that qualify, you can deduct a portion of most of your utilities in addition to the square footage deduction.

  • Medical - With medical costs soaring, you'll want to save every receipt that is even remotely related to any kind of medical care. This envelope would include receipts for co-pays, prescription costs, dental work, mental health counseling, alternative medical treatments, and even over-the-counter medications and remedies. You'll even want to stick in a note recording your mileage each time you visit the doctor.

  • Charitable - Whenever you lend a helping hand, the IRS helps you right back. But as with every other type of deduction, you've got to be able to prove it. You'll want to keep all your donation receipts, canceled checks, appraisals for large non-cash gifts, and a detailed list of clothes and goods you donate. Be sure to keep your receipts for any food or other goods you buy and donate, as well as mileage you drive doing charity work - both are deductible. (For more on this read, Deducting Your Donations.)

  • Unreimbursed Business Expenses - If you work for someone else, expenses you incur in the line of work that don't get reimbursed may be deductible. This may include expenses such as uniforms, meals, materials and mileage. Be sure to also save the stubs from any reimbursement checks you do receive, just to avoid confusion later.

  • Dependent Care Expenses - Money spent on care for a child or an elderly parent may earn you a handsome tax credit. Be sure to save all your receipts for these expenses.

  • Education Expenses - The IRS provides substantial relief for parents and students tackling the rising costs of higher education, through a number of deductions and tax credits. This envelope is the place for your tuition bills, book receipts and student loan statements.

  • A Car Log - If you plan on driving a lot of miles for work, medical attention or charity, consider keeping a small spiral notebook with a pen in your glove box. Before you get out of the car at the end of the day, write down the different places you drove, the mileage for each and your purposes for going there. An organized logbook will make it much easier to deduct your mileage than trying to go back over the whole year at tax time.

  • Everything Else - Use this last folder for all your other receipts, even if you don't think it will be deductible. Even the most organized and knowledgeable taxpayers often discover things they've missed at tax time. From time to time as well, the tax laws will change mid-year, permitting a new kind of deduction not previously accounted for.
Choose a safe location in your home for this box full of goodies. If at all possible, avoid storing it in your garage, since your garage more easily burglarized than your home. After you file your return for the year, take all your envelopes and a copy of your return and wrap it up nicely in a large folder or brown grocery box. Tape it up like a gift and keep it that a separate box right next to your current year's files. As times go on, you can shred everything older than seven years.

Using Personal Finance Software
For anyone expecting to itemize their deductions, especially those with frequent deductible expenditures, personal finance software can go a long way towards keeping you organized. By using programs such as Quicken and Microsoft Money, you can quickly download every transaction from your different bank and credit card accounts, easily sorting them into pre-selected expense categories (like the envelope system above). Then, with the push of a button, these programs will upload all your info into any of the leading tax preparation programs. Even if you're having someone else do your taxes, you can print out an itemized report that'll save your accountant time and you money.

Of course, if you do use personal finance software, be sure to hang on to your paper receipts. While you won't need to go to all the trouble of organizing them (that's what the software is for), you still may need them if you get audited. (For further reading on this subject visit our Income Tax Special Feature.)
Personal Income Tax Guide: Moves To Make Before December 31

  1. Personal Income Tax Guide: Introduction
  2. Personal Income Tax Guide: Basic Concepts
  3. Personal Income Tax Guide: Documentation And Records
  4. Personal Income Tax Guide: Moves To Make Before December 31
  5. Personal Income Tax Guide: Moves To Make Before April 15
  6. Personal Income Tax Guide: 6 Overlooked Deductions And Credits
  7. Personal Income Tax Guide: Common Filing Mistakes
  8. Personal Income Tax Guide: Avoiding Nasty Surprises
  9. Personal Income Tax Guide: Conclusion
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