4 Mistakes to Avoid During Tax Season

Key Takeaways

• You can do QCDs, qualified charitable distributions, before RMDs begin. So you have a little gap there to start knocking your IRA balance down. You do a transfer from your IRA to the charity. Why are there mistakes on that? Because there is no code. When you take money out of an IRA, you’re going to get a 1099-R just as if you took an RMD or any other distribution. There is no special code to signify that this is a QCD and it’s not taxable.
• Another frequent place where people stub their toe relates to these backdoor Roth IRA contributions that people have been making in a piece of paperwork that needs to get filed along with the tax return to substantiate that the contribution consists of nondeductible dollars.
• The 3.8% Medicare surtax is another thing that sometimes gets missed.
• Like with the QCD, you have to report rollovers the right way. Now most rollovers will be tax-free. You go from a 401(k) to an IRA or an IRA to another IRA, and a lot of them will be coded as rollovers, but you could miss it. People look and they say taxable amount, gross amount, but the taxable amount may be zero.

Christine Benz: Hi, I am Christine Benz from Morningstar. We’re in the midst of tax season, and tax and IRA expert Ed Slott said that there are some mistakes that he sees people make with their tax returns year in and year out. He’s here to discuss those with us today. Ed, thank you so much for being here.

Ed Slott: Great to be here. Thanks, Christine.

Qualified Charitable Distributions and Tax Errors

Benz: We want to delve into some of the mistakes that people make when they are in the midst of tax season, some of the things that you see tend to get missed. And you said one that is coming up a lot is related to this qualified charitable distribution. Maybe you can first discuss what that QCD is, who can take advantage of it, and also how people sometimes miss a little bit of the accounting that they need to be doing.

Slott: The QCD, qualified charitable distribution, and we’ve done a few programs on this, but you can never do enough. I think it’s one of the best benefits in the tax code. The only negative side, and before I give you the negative, let me tell you what it is. It’s a direct transfer from your IRA to a charity. Why is that a big deal? Because most people, actually, 90% of the people, according to IRS’ own numbers, 90% of the people get no tax benefit from their charitable donations.

Why? Because they take the higher standard deduction. It’s so high now that most people don’t qualify for itemizing, and charity is itemizing. That’s where you get your charitable deduction. So yes, they get the benefit of giving but not the tax benefit. This replaces even better than the tax benefit because you can take it right from your IRA, a direct transfer to a qualified charity and it’s not included in income.

So you’re getting that IRA money out at 0% tax rate to give the gifts you were giving anyway. I never say, and I say this disclaimer or warning every time I talk about giving to charity, I never say to do it for tax benefits. That is not why. I’m talking about people who give anyway, charitably inclined people. If you’re giving anyway, do it this way and you’ll save money in taxes if you’re giving anyway. But the downside is, and it’s not a real downside, it’s the qualifying rules.

Why? Because it only applies to IRA owners or IRA beneficiaries who are 70 and a half years old or older. It doesn’t apply from company plans. And I said 70 and a half. Some people will say, “Oh Ed, don’t you know the age is 73?” No, I know that, but this provision, the age never changed. You can actually do QCDs before RMDs begin. So you have a little gap there to start knocking your IRA balance down.

So you do a transfer from your IRA to the charity. Why are there mistakes on that? Because there is no code. When you take money out of an IRA, you’re going to get a 1099-R, just as if you took an RMD or any other distribution. There is no special code to signify that this is a QCD and it’s not taxable. And that is done purposely because the IRS has determined “We’re not going to be the police. We don’t know if you took that money and really gave it to the charity. That’s up to you.” And the institutions didn’t want the code because they don’t want to police it either.

So you have to know. Let’s say you use an accountant, or even if you do your own, but you give your 1099s in to a preparation service, an accounting firm or something. They may just look at the 1099, “Oh, taxable.” “$100,000, taxable.” No, I did a $100,000 QCD. That’s how much you can do. Actually, in 2024 you can do $105,000. It’s up from inflation under Secure 2.0. But you have to itemize that, and most tax programs will prompt you. But you have to know, look down on the menu, it’s way down there, and check that box, you have a QCD. If you check it, let’s say you did a $100,000 or $10,000, any number. $10,000—let’s say you did that, and you have to, when you get the 1099, it’s going to show $10,000 as a regular taxable distribution. You have to check that box —$10,000 QCD—and what we’ll print out on the return is $10,000 gross, but zero taxable, and it will write the letters out on the return—QCD. Many people miss that. I don’t know how many, but I’ve heard stories where people miss that, then they have to go amend or they go back, “How could this be? I thought it was tax-free. There was no code.” Purposely no code. So you got to watch out for that one. That’s a recurring error we see on returns.

Benz: OK. And presumably you’d want to make sure you have the documentation from the charity?

Slott: Oh, yeah. Obviously, yeah.

Benz: Substantiating.

Slott: And you could see that. You should see it on your statement. It’ll identify QCD going to the YMCA or your alma mater or something like that.

Backdoor Roth IRA Contributions and Nondeductible Dollars

Benz: You say another frequent place where people stub their toe relates to these backdoor Roth IRA contributions that people have been making in a piece of paperwork that needs to get filed along with the tax return to substantiate that the contribution consists of nondeductible dollars. Can you talk about that?

Slott: It’s not only the backdoor Roth. Any IRA distribution where you have aftertax dollars in your IRA that come from generally making nondeductible contributions, you get credit for those. But you have to report them on Form 8606. And again, the tax programs are great on this. Again, garbage in, garbage out, if you put the info in. If you don’t put the info in, it’ll all show up as taxable, and you won’t keep track of your basis each year, your aftertax money. Because if you don’t take credit for that, in effect, you’re paying tax twice on the same money.

So make sure if you have aftertax funds and you take an IRA distribution, you file Form 8606, which keeps a cumulative record of all your nondeductible contributions. So when you pull anything out of an IRA, you’ll always have that percentage of what’s taxable and what’s tax-free. But you have to do things. You have to enter the input, which can be a little confusing. Again, even if you have the tax program, you have to look and make sure you put in the basis.

One of the questions on the 8606, “What’s your basis and what’s your value of all your IRAs?” But how much accumulated basis? How much have you made in nondeductible IRA contributions? And that goes as well for inheritors because people inherit IRAs and sometimes they didn’t realize their parents had nondeductible contributions. And when they take out the inherited IRAs, look back at the parents’ 8606 to get credit for those aftertax contributions, that’s almost always missed. Beneficiaries don’t usually think of that. They say, “Oh, here, I’m taking a distribution from my dad’s IRA, inherited IRA, it’s all taxable.” Maybe not if they made aftertax contributions.

Benz: Right. And it seems like pre-backdoor, those aftertax contributions were pretty popular. People would make those nondeductible IRA contributions.

Slott: Yes. So a lot of people have them, and you have to keep track of them on Form 8606 for your own benefit, to take credit for funds that were already taxed.

How to Report Rollovers the Right Way

Benz: You say that rollovers, if someone has done a rollover in a given year that there can be snafus there, too.

Slott: Well, again, like with the QCD, you have to report it the right way. Now most rollovers will be tax-free. That’s the whole point. You go from a 401(k) to an IRA or an IRA to another IRA, and a lot of them will be coded as rollovers, but you could miss it. People look, and they say gross amount, but the taxable amount may be zero. So you could roll over your $300,000 401(k) to your IRA. You’ll get a 1099. It should be coded rollover, but you have to watch it. Obviously, you should know that you don’t have tax on $300,000. That’s a tax-free rollover. Most rollovers are tax-free. So make sure that they are tax-free.

And some of the mistakes people make is because they didn’t do direct transfers. Always do direct transfers, never do the 60-day rollover. Sometimes you don’t get the money back in 60 days. Don’t do a take a check from a 401(k), like in my example, $300,000. If you don’t do a direct rollover to your IRA, you could have a tax because they take... Let’s do an easier example. Let’s say you have a $100,000 in your 401(k) and you want to roll it to your IRA, but you take a check made out personally to you and you roll the money out, you’re not going to get a $100,000. You’ll only get $80,000 because if they make the check to you, by law, they’re required to take 20% withholding. So now you only have $80,000 to rollover if you have the other $20,000 laying around to make it up. But if you don’t, you could have a tax on the $20,000. That’s why you want to do direct rollovers and report them correctly on your tax return. You should generally have an idea. If you did a tax-free rollover, obviously there should be no tax, but the IRS won’t know that. They might if the coding is right. But you could actually undo that by not showing it yourself as tax-free.

Don’t Forget the Medicare Surtax

Benz: And you say that that 3.8% Medicare surtax is another thing that sometimes gets missed. Can you talk about what that is and how that works?

Slott: It sneaks up on people. I wouldn’t say it gets missed as much. It gets missed in the expectation of what your tax bill would be. Because the programs are really good, and most people use tax programs. I don’t know anybody who does it by hand anymore. But if you do it by hand, you could miss that, that’s for sure, because you got to go to other forms. So let’s not talk about that one guy who’s still out there doing it by hand. He’s probably doesn’t even have a computer, so he can’t even watch this.

All right. Other than that person, most tax programs put it right over. It’s an extra tax on investment income, interest, dividends, capital gains. There’s even a version on self-employment income. So it can add up once you’re over the thresholds, which have never been updated for inflation. They’re high thresholds, but lots of people are over them.

And you get your bill and say, “What is this? What are these forms for? The net investment income tax, what is that?” So it throws your estimates off and maybe you’re short. So I think if I called it a mistake in expectations and not realizing that you even have this tax, and here’s how it sneaks up on you. Many people say, “Oh, I don’t have a lot of capital gains.” And you know this one being in the mutual fund industry: What happens every December?

Benz: Distributions.

Slott: Yeah. Right. “But I lost a fortune.” Then the distributions are even higher in those years. And then you get your 1099, and it shows a $100,000, $200,000 in capital gains. “That’s not true. It’s got to be a mistake.” And then you do your return, then that triggers the 3.8% net investment income tax. It’s like the dominoes just fall against you.

But that leads to another mistake. And a lot of brokers or investment reporting and statements cover this, but not always: not taking credit for money you already paid tax on, on dividends. I’m talking about reinvested dividends. In the old days, people used to get, really old days, before even my father, I think. Although not true, I used to do tax returns for clients that got, “Oh, I got this dividend check.” They used to get a dividend check from IBM, from this one, all these blue-chip stocks. But that’s kind of gone away. Most people just reinvest everything, but they still pay tax on that dividend even when they don’t get it and they reinvest it. So when you eventually sell the stock, you have to give yourself credit for all the tax paid, the reinvested dividends on all the back years.

Now some providers, some people that do the statements, the institutions keep track of it, but it doesn’t always happen. Especially if you change from, let’s say, Schwab to Vanguard to Fidelity and go... We don’t know if that information is carrying over. So that’s up to you to give yourself credit. You may be amazed if you go back to your tax returns, I used to do this with clients, all the dividend income, the reinvested dividend income for years and years when they finally sell the stock, it usually wipes out the whole gain.

Benz: Ed, this has been such a helpful roundup of some of the mistakes that you see people making at tax season. Thank you so much for being with us today.

Slott: Thanks, Christine.

Benz: Thanks for watching. I’m Christine Benz for Morningstar.

Watch “Backdoor Roth IRA: Is It Worth the Effort?” for more from Christine Benz.