(This is part 2 of the Set Your Financial Records Right series.)
Let’s start with everyone’s favorite subject – taxes. You’ll want to start a file for this year’s tax return and use it to store all the paperwork you or your CPA will need to prepare your return. This includes all your income records, like W-2 and 1099 forms, as well as back-up documentation for deductions, including receipts and cancelled checks. When tax season rolls around, you’ll appreciate having all this paperwork organized and in one place.
With the exception of last year’s return, which you may need to refer to from time to time, all previously filed tax returns and supporting documentation can be moved to your dead storage area.
But how long should you let those old tax returns collect dust in dead storage? That’s the question I am probably most often asked. The absolute minimum is three years after you file, because that is how long the IRS has to audit your return. However, you should keep in mind that the limit increases to six years if the agency suspects you have underreported your income by 25 percent or more. Furthermore, the IRS can come after you anytime if it believes you have committed fraud or failed to file a return. To play it safe, my advice is to hold on to your returns for six to 10 years. That way, you’ll be covered no matter what.
In case you haven’t kept your old returns and need to present them, ask your tax preparer for a copy, or you can request copies from the IRS.
Now, let’s turn to banking records, which probably make up a large portion of your financial paperwork. Between saving statements, checking statements and cancelled checks, the clutter can accumulate quickly. You’ll want to have separate files for your savings and checking accounts and keep all of your statements for the current year.
When you receive your year-end 1099 forms from the bank listing any interest earned, check it against your statements. If your 1099 forms are correct, go ahead and discard your monthly statements.
What about cancelled checks? I know people that have boxes stuffed with every check they’ve ever written. It’s really unnecessary and a waste of valuable storage space. In fact, most cancelled checks can be discarded after a year. Of course, there are a few exceptions.
All checks that support tax deductions, such as those for charitable contributions and tax payments, should be saved and filed with your tax return. Similarly, for reasons we will discuss in a few minutes, keep cancelled checks related to a home purchase, capital improvements to your home and non-deductible IRA contributions. Before discarding your cancelled checks, pluck these out and file them in the appropriate places.
Like your bank records, you’ll need to start files for all of your investment accounts and stash your monthly statements in the appropriate files. Make sure you have plenty of space available. Investment sales may trigger the capital gains tax so you must keep records to substantiate the amount of your gain.
Save all paperwork on the purchase of the investment, its sale, and any activity that occurs in between. Since you must keep these records for several years after you sell, you could be holding on to these files for many years.
But saving investment records is a tax-saving necessity. Commission charges, fees, and reinvested dividends and capital gains increase your basis in the investment and reduce the tax bill when you sell. However, not all fees increase your tax basis. Most brokerage fees must be deducted as a miscellaneous itemized deduction subject to the 2% floor.
Let’s say, for example, you bought $1,000 worth of shares in a mutual fund and instructed the fund manager to reinvest your dividends every year. In the first year, the fund paid $100 in dividends which were reinvested in additional shares. And even though you never actually held that $100 in your hand, you must pay income tax on it come April 15.
However, if the dividends are tax-exempt, they generally are not added to your tax basis.
Now imagine a few years have passed. You have reinvested a total of $200 in dividends, paid your taxes, and kept meticulous records. Your $1,000 investment now has a cost basis of $1,200 due to those reinvested dividends. If you sell your shares for $1,500 your gain is $300. Many a taxpayer have overlooked those reinvested dividends and paid Uncle Sam twice. Don’t let it happen to you. Hold on to all of your investment records for at least three years after you sell.
We’ll continue this discussion in the next post.