• Taxes & Insurance

Advantages Of Filing For A Tax Extension

April 13, 2014 | Justin McCurry

If you haven’t filed your 2013 taxes yet, you are probably feeling anxious as the looming April 15 deadline draws near. Filing for an extension might be the answer to your problems. Although the majority of taxpayers submit their tax returns by the regular April 15 due date, each year ten million filers request a six month extension to October 15.

The reasons for requesting an extension vary from taxpayer to taxpayer. Some need more time to gather their documents while others couldn’t schedule a time with a tax preparer. Some taxpayers simply procrastinate and allow the deadline to sneak up on them. All of these individuals can receive a six month reprieve on the tax filing deadline. You don’t need a reason to receive an extension – it’s automatic, no questions asked.

Why File A Tax Extension?

Most people like to follow the rules and get things done on time. For some people it’s simply not possible to complete their tax returns by the April 15 deadline in spite of their best efforts.

For example, small business owners often have to wait for their business tax return to be completed before they can file their own personal tax return. The schedule K-1’s from their partnership or S corporation may not be available by the regular tax filing deadline, thereby requiring the taxpayer to file for an extension.

Even your run of the mill salaried employee might not be able to meet with a tax preparer before the regular April due date. I often receive a revised 1099-DIV form for my brokerage account in the middle of March due to a single mutual fund I own. The mutual fund usually files their required tax forms in late February or early March.

My broker can’t prepare an accurate 1099 for my account until they receive the tax information from the mutual fund. If I were to try to find a tax preparer in late March or early April, I may have difficulty getting my tax return prepared by the due date.

Can An Extension Reduce The Risk Of An Audit?

If you have ever received an unexpected thick envelope with “INTERNAL REVENUE SERVICE” in the return address field, your heart will skip a beat. At least mine did when I received one of those letters. It turned out to be a simple clerical error at the IRS and a phone call cleared everything up. But for a few days, I was genuinely concerned (with good reason) that I would owe the $35,000 in back taxes claimed by the IRS.

From personal experience, I can tell you that a tax audit, or “examination” as the IRS politely terms it, is not a fun experience even when the audit is resolved with a simple phone call and no additional tax or penalty is due.

One of the best ways to avoid an audit is to ensure you have enough time to properly and accurately complete your tax return. That may mean filing for an extension if you run out of time before April 15. Math errors and data entry errors are the most common reasons to flag a tax return for review by the IRS. These errors are also the easiest to avoid by carefully checking your tax return before submitting it to the IRS. After all, if the IRS is looking closely at your return due to a math error, the examiner might find other areas on your tax form that pique his curiosity.

It’s great to be noticed in some parts of life, but you should keep your tax return as boring as possible.

If you find out later that you messed up, it’s possible to file an amended return on Form 1040-X to fix your mistake. The bad news is that amended returns can receive more scrutiny than an initial filing on Form 1040 and increase your risk of an audit.

One rumored advantage of filing an extension is bypassing the initial onslaught of tax returns that go through the normal selection process for an audit. By the time those tax returns with an extension are filed in October, the IRS examiners have met their “quota” of returns to flag for an audit or further review. Or so goes the theory. The IRS’s audit process is an opaque black box, and very few know the inner workings of the system. At the least, we can conclude there is no increased audit risk by filing in October after taking an extension, and there may possibly be a lower risk of audit when returns are filed after IRS examination quotas are met.

What Increases The Odds Of An Audit?

Rumors and whispers aside, the IRS does a great job of releasing detailed statistics on every facet of taxation imaginable. For all individual tax returns in 2013, the IRS audited 1 out of 100 returns.

For the average salaried taxpayer earning less than $200,000 the odds of an audit are lower at 1 out of 250.

Factors that increase the chance of an audit are:

  • Taking the Earned Income Tax Credit.
  • Having business income.
  • Earning over $200,000.

Taxpayers with income over $1,000,000, for example, have a 1 in 9 chance of being audited by the IRS. In 2013, IRS audits uncovered a total of $37 billion in tax underpayments. Filing a proper return will keep you from contributing to that sum of money. 

Other Benefits Of Filing For A Tax Extension

Taxpayers that take advantage of certain tax strategies can gain time to make a more informed decision and possibly reduce their taxes. For example, taxpayers that convert funds from a traditional IRA to a Roth IRA can later recharacterize the conversion back to a traditional IRA at any time before the tax filing deadline. The “deadline” is usually April 15.

However, filing an extension actually extends the deadline to recharacterize the conversion to October 15. The extension effectively buys the taxpayer an additional six month period to determine whether it makes sense to pay taxes on the Roth conversion.

If the market crashes after you convert to a Roth, you are normally better off undoing the conversion through a recharacterization and then reconverting the post-crash amount. As an example, let’s consider a $50,000 traditional IRA that the owner converts to a Roth IRA. The $50,000 conversion will be treated as income and the taxpayer would owe $12,500 in federal income tax on the conversion at an assumed 25% tax rate.

If the $50,000 investment declines in value to $30,000, then the owner of the IRA could save on taxes by recharacterizing the conversion back to a traditional IRA, then immediately re-convert the $30,000 traditional IRA back to a Roth IRA. The new amount converted, now only $30,000, would be treated as income and incur $7,500 in taxes at an assumed 25% rate. In this case, the recharacterization could save the taxpayer $5,000.

By filing for an extension, the IRA owner has six additional months (until October 15) to monitor the value of the converted Roth IRA and to decide whether to undertake a recharacterization to save on taxes.

How To File A Tax Extension

To file for an extension, use Form 4868 “Automatic Extension of Time to File”. The deadline for filing an extension is the same as the regular tax return deadline. You must have the request for an extension postmarked by April 15 if submitting the request by mail. The IRS also permits e-filing the extension request (also due by April 15).

form-4868

Pay Taxes With An Extension To Avoid Penalties

Remember that extensions only postpone the tax filing deadline. Any tax owed is still due on April 15. When filing Form 4868 to request an extension, the taxpayer should also pay an estimate of any taxes due in order to avoid interest and penalties. Interest and any penalties start to accrue after the April 15 filing deadline.

If a taxpayer waits to pay taxes at the same time as filing their return on the extended October 15 deadline, an additional 0.5% per month penalty will be assessed on amounts owed, in addition to interest on any amounts owed (currently 0.25% per month). Over the course of six months, the interest and penalty will add 4.5% to any tax still due after April 15.

Filing for an extension will allow the taxpayer to avoid a more punitive 5% per month penalty for late filing. In other words, it’s better to file an extension and try to come up with taxes due by October 15 (and pay a small penalty for late payment) than to not file for an extension and accrue a 5% per month penalty (in addition to interest) for late filing and late payment.

There Are Many Benefits To Filing A Tax Extension

Filing for an extension can be a smart choice for many taxpayers. You can file for an automatic extension and enjoy six more months to get your documents in order and properly prepare your tax return. With roughly 10 million other extension requests filed annually, you won’t be alone.

There is no stigma attached to filing for an extension. The IRS will not hold it against you or mark your tax return for an audit. In fact, taking extra time to ensure your tax return is completed accurately without errors will reduce your audit risk.

The automatic filing extension is just another tax tool available to all taxpayers to allow them to properly file their taxes and pay the correct amount due.

While filing for an extension generally won’t cut your taxes due this year (other than the recharacterization trick mentioned earlier), here are some great suggestions to slash next year’s tax bill.

Have you ever filed for an extension? Was it due to procrastination or a legitimate business reason? Be honest! As always, speak to a tax professional for further advice.

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// photo credit: Financial Samurai Safari West, CA.

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