3 Critical Tax Penalties to Avoid at All Costs

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Tax penalties can make your tax bill skyrocket. We asked our Motley Fool tax experts what are the biggest tax penalties you need to avoid.

: If you can't file your taxes by April 15, it is critical to know that no matter what you must file for at least a tax extension by April 15 and pay your estimated taxes by then as well. If you don't, you will face either or both the failure-to-file or failure-to-pay penalties.

If you file for an extension by April 15, you have another six months to file your taxes and the failure-to-file penalty does not apply. If you don't file either your taxes or for an extension, know that the failure-to-file penalty is generally larger than the failure-to-pay penalty. The penalty for filing late is a whopping 5% of your unpaid taxes for each month that your return is late and is capped at a maximum 25% penalty. However, if you wait longer than 60 days after the due date to file, the minimum payment rises to the smaller of $135 or 100% of the unpaid tax. Either way, that's a big penalty, make sure you file by April 15.

If you file your taxes or file for an extension, either way you must pay your taxes owed by April 15. If not, the failure-to-pay penalty is 0.5% of your unpaid taxes for each month after the due date that the taxes are not paid. This penalty is also capped at 25% of your unpaid taxes though that would mean that you haven't paid taxes owed for four years.

Lastly, know that if you have a reasonable cause for not filing or paying on time you will not have to pay a late-filing fee but you must show that you "exercised ordinary business care and prudence, but due to circumstances beyond your control, you were unable to comply." Reasonable causes include:

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  • Death, Serious Illness, or Unavoidable Absence
  • Fire, Casualty, Natural Disaster, or Other Disturbance
  • Unable to Obtain Records
  • Ignorance of the Law
  • Statutory Exceptions or Waivers
  • Written or Oral Advice From IRS
  • Official Disaster Area
  • IRS Error

Some special cases but generally not accepted include:

  • Mistake was Made
  • Advice from a Tax Adviser
  • Forgetfulness
  • Undue Hardship

Dan Caplinger: For those who look to save as much as they can for retirement, keeping track of all the limits on contributions can be hard. But if you go over the limit on certain retirement savings accounts, such as IRAs and 401(k)s, then the IRS will hit you with a penalty that can go on indefinitely until you fix the problem. The amount of the penalty is 6% of the excess above the contribution limit, and you have to pay that amount every year that you keep the excess contribution in your retirement account. The most common reason why people end up with excess contributions is that Roth IRA contributions get phased out if your income rises above certain levels. Confusion about which tax year a given IRA contribution gets attributed to can also cause problems.

Fortunately, it's fairly easy to fix the problem before the penalty hits. At any point during the year, if you discover you've made an impermissible contribution, you can make a correcting distribution to reverse the problem and avoid the penalty. The trick is that you also have to take out any income that the excess contribution generated as well. As long as you fix the problem by the due date of the return for the year of the contribution, you won't owe any penalties. With the potential for multiple years of penalties, though, it's important to fix any problems as soon as possible.

One thing you really want to avoid is taking business deductions you don't qualify for, since the penalty can be rather severe.

For example, let's say that you claim a "home office deduction" in the amount of $1,500 for your guest bedroom, which happens to have your work computer in it. However, in order to claim the deduction, you need to have a room (or rooms) in your home that is used exclusively to conduct your business.

If the IRS decides to audit you, and determines that you don't qualify for the deduction, the amount will be added to your business income and you'll have to pay Federal and state taxes, as well as the 15.3% self-employment tax. So, if you are in the 25% Federal tax bracket, and your state tax rate is 6%, this could mean an extra $664 in additional tax liability. And that's not including any interest or late payment penalties you'll have to pay.

The same principle applies to other business deductions, such as business meals and entertainment, travel expenses, and more. If the IRS finds that any of the deductions you took on your tax return were excessive, you could find yourself with a pretty large tax bill.

The article 3 Critical Tax Penalties to Avoid at All Costs originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. Dan Dzombak has no position in any stocks mentioned. Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.