When it comes to your taxes, good records are the best protection you can have if the government decides to audit your returns. But just as important as your effective recordkeeping are the measures you take to make certain that your records are kept safe. While it may cause a chuckle to picture a mythical taxpayer confessing to an IRS auditor that tax records were destroyed by the family pet, it probably wouldn’t be nearly as funny to give a similar response in a real audit of your own. The Advantage of Good Records A good set of records can help you cut your taxes. Detailed records reduce the chance that you will overlook deductible expenses when your tax return is prepared. After all, how many people remember the exact details of their expenditures months after the fact? Nothing is more frustrating than knowing you incurred deductions yet not being able to prove them. The ultimate consequence of poor recordkeeping is enforced payment of more tax than the law requires. Explicit records provide the best assurance of a favorable outcome if you are audited. Oral testimony alone is seldom enough to prove the deductions you claim on your tax return – auditors want to see a paper trail of receipts, logs, etc. When you’re missing adequate backup records, it can cost a great deal in time and effort to get duplicates. The unfortunate fact is that many businesses balk at hunting down receipts for past sales (you can’t really blame them since it raises their expenses). Your ongoing recordkeeping effort is your best remedy to counteract this problem. Good records help others who might have to handle your financial affairs in an emergency – e.g., an illness. The better your records are, the easier it could be for someone else to temporarily “step into your shoes” to handle your monetary transactions. Tracking IncomeHow you track your income is largely dependent on the type of income you are receiving. For certain kinds of income, you will receive statements from the income payers to tell you the amount. These statements are called “information returns” by the IRS. Examples include: When you receive an information return, you should compare it to your own records, and if there is a discrepancy in the amount of income reported, you should determine whether your records or the payer’s are in error. If you find your records are accurate, contact the payer to issue a corrected information return or explain to you how they determined the amount they have reported. Be sure to keep information returns you receive in a safe place so that the amounts reported on them can be shown accurately on your tax return. Payers must submit the data to the government as well as to you. The IRS will compare what they have received with your return to see that your reporting and their data match. If there’s a mismatch, you will get a letter asking ‘Why?’ or assessing additional tax. Since the IRS may misinterpret return reporting, check carefully before paying any extra tax they try to assess! Income From Other SourcesIncome not traceable to information returns also needs to be reported on your tax return. It could include such items as: Receipts from a self-employed business; Rental income; Interest income on a personal loan. Taxpayers who receive income from sources like these have a more complicated job in tracking it. It’s recommended that you record it in a separate ledger or through a computer spreadsheet program. In addition, you may want to deposit the funds in a separate bank account earmarked for that income alone. Getting Organized No one method is the only way to maintain your records. What’s important is to develop a system that is the most convenient and comprehensive for your situation, and then to stick to it. The IRS estimates that a non-business taxpayer who files a 1040 return will spend about eight hours doing recordkeeping. For a more complex return, such as one with rental properties or self-employment income, add at least another five hours. The following suggestions may help you organize your records, and also reduce the time you spend doing so. Decide first if you will maintain your records manually or by computer. Bookkeeping software - Some taxpayers, even though they aren’t operating a business, choose computerized “bookkeeping” software that uses their check register data to track their income and expenses by category. Monthly and yearly reports conveniently recap the income and expenses, especially if the accounts (income and expense categories) are consistent with how the information is reported for tax purposes. Spreadsheet method – In lieu of purchasing bookkeeping software, a spreadsheet file (for example, in Excel) may be set up where you record your yearly income and expenses by tax return category. If you normally itemize your deductions, set up a separate sheet for each of the major deduction categories –medical, taxes, contributions, etc. – as found on Schedule A. For medical expenses, for example, record each expense by provider’s name, type, date, amount paid, and payment method. Note medically related auto mileage at the same time. At year’s end, sort income and expenses of the same type together to get a yearly total. For income items, a cross-check from the spreadsheet to the 1099 forms for all bank interest or other income sources is an accurate way to verify that all needed 1099s have been received. If your tax advisor gives you a “tax organizer” to help you prepare for your appointment, you can quickly transfer the totals from your spreadsheet to the organizer, or, instead, you can provide your advisor with a copy of the spreadsheet. Manual lists – If you keep track of your records manually, the same type of system applies as for a spreadsheet, except you’ll set up a paper sheet for each category of income and expense that you normally have on your tax return. Write each payment you receive or expense you incur on the applicable list. At the end of the year, each list is ready to be totaled. If you make your entries no less frequently than monthly, you’ll find that the overall time you spend will be less, and the accuracy of the information will be greater, than if you wait until just before your tax appointment to put together the year’s lists.