Clearing Up Common Tax Misconceptions

Written By: Brian Ellenbecker, CFP®, EA, CPWA®, CIMA®, CLTC®

The United States Tax Code is incredibly complex. The tax code itself is currently almost 7,000 pages long. If you add in the Treasury Department’s official interpretation of the code, it’s closer to 75,000 pages!

It’s no wonder so many people have misconceptions about how the tax code works. Unfortunately, this can end up costing people real money. Even small mistakes can lead to relatively large tax costs. Let’s clear up some of the most common misconceptions to protect you from potential mistakes that could cost you money on your next tax bill.

Myth: All your income is taxed at the same rate.

Ordinary income tax rates under the US tax code are progressive, meaning your average rate increases as your income increases. Under the current code, the first dollars you earn are taxed at 10%, the next dollars at 12%, then 22%, 24%, 32%, 35%, and 37%. However, if you have income that puts you into the next tax bracket, only that income above a certain threshold is taxed at the next highest rate. Moving into the next tax bracket does NOT pull income previously taxed at a lower bracket into the higher bracket.

Also, if you have income from long-term capital gains or qualified dividends, that income is taxed at lower rates of 0%, 15%, and 20%.

Myth: You will be in a lower tax bracket once you retire.

People assume once they stop working, they will be in a lower income tax bracket. While that will certainly be true for some, many people are surprised to find that they end up in the same or a higher bracket once they stop working.

While your employment income will be gone, you will potentially have income from Social Security, retirement account withdrawals (which become required at 73 or 75), pensions, and investment income, to name a few. Your spending levels often dictate how much income you need and it’s not uncommon for people to see their spending increase in the first few years of retirement while they take trips or do other things they have been wanting to do, but didn’t have the time while working. Even if you end up in the same or lower tax bracket, you may see a spike in certain years if you need to take a larger withdrawal to meet a spending need or sell a large investment (real estate, business, etc.).

Myth: Filing an extension buys you more time to pay your tax bill.

While filing an extension gives you more time to submit your tax forms to the IRS, it does not delay the payment deadline. Tax payments are still due on April 15. If you fail to pay the full amount due, you will be subject to interest and penalties on the amount you still owe.

Filing for an extension is becoming more common, and it’s not necessarily a bad thing. 1099s seem to be issued later and later. If you have private investments that issue K-1s, these are often issued much later in the tax season, if not after April 15, which makes filing an extension more likely.

Don’t be concerned if you need to file an extension; just remember to pay your tax bill by April 15 when you request your extension.

Myth: You wait until you file your return to pay your tax liability.

If you’re not having taxes withheld from income (like your paycheck, Social Security, etc.), you have to make estimated tax payments quarterly. The IRS wants you to make your tax payments evenly throughout the year. If you fail to pay enough tax throughout the year, you could be subject to an underpayment penalty.

As long as you pay 90% of the current year’s tax liability or 100% of your prior year’s tax liability (110% if your prior year AGI was over $150,000), you won’t owe any penalties when you file your return.

Myth: It’s a great result if you receive a large tax refund.

While it feels good to receive a large check from the IRS or your state when you file your return, it’s actually not a good result from a tax planning standpoint. The best result is usually to owe a small amount when you file your return while ensuring you avoid the underpayment penalty.

Why is that? If you receive a refund, you’ve given the government a tax-free loan. That’s money you could have used throughout the year. For example, you could have had less withheld from your paycheck, Social Security payment, pension, etc., making it larger and giving you more “take-home pay.”  If you’re making quarterly payments, you could have kept the money in a savings account, earning more in interest throughout the year.

Related to this point, a common misconception we hear is why your refund/amount owed is different than last year. That is simply a function of how much you paid to the IRS vs. what your tax liability for the year is. If you want to be sure you only owe a certain amount or get a particular amount as a refund, make sure you’re paying the proper amount of tax relative to the size of your anticipated tax bill.  Working with a tax professional to project your income, deductions and resulting tax liability is the best way to ensure there won’t be any surprises come next tax filing session. They can help you adjust your withholding or quarterly tax payments to ensure you’re paying the proper amount each year to achieve the desired result.

Myth: You don’t have to report income if you didn’t get a tax form.

The rules determining whether income is subject to tax apply whether or not you get a tax form showing you had the income. The most common scenarios where this happens is if you sell items on an online marketplace or use a payment app like PayPal, Venmo or Zelle.

This has been a hot topic lately, as Congress has lowered the threshold for reporting this income on a 1099-K. The income threshold for generating a 1099-K was dropped from $20,000 and 200 transactions to just $600 in income. However, this rule has been adjusted to be phased in gradually. For 2025, the income threshold is $2,500 with no transaction limit. It’s expected to drop to $600 next year and beyond.

However, whether you receive a form doesn’t change your requirement to report the income on your return. For example, if you are generating income from business activities like freelancing or side gigs, or if you have a gain on property sold, you most likely have to report that income on your return and pay any resulting tax liability.

Myth: You’ll owe tax if you receive an inheritance.

It’s extremely rare for the recipient of an inheritance to owe any tax at the time the inheritance is received. There is no federal inheritance tax. Six states still impose an inheritance tax, although most of these only tax an inheritance if the recipient is not a member of the immediate family.

There is a federal estate tax imposed on only the largest of estates, but that tax is paid by the decedent’s estate, not the beneficiary of the inheritance.

It is possible that taxes may be due once the inherited asset is sold, although the basis is adjusted to the date-of-death value, so gains are likely to be small if sold shortly after death. Withdrawals from retirement accounts would also likely result in taxable income to the beneficiary.

Certain assets, such as life insurance and Roth IRAs, are almost always tax-free to the recipient.

Myth: If you pay someone to prepare your taxes, they are liable for any mistakes on your return.

If there is an error on the tax return your accountant prepared, you’re most likely the one that’s on the hook for the mistake. Every taxpayer is responsible for the information on their own return, even if they hire someone to prepare it on their behalf. When your preparer sends you the return to review before submitting it to the IRS, it’s a step you should take seriously.

If it’s truly their error (math mistake, something reported incorrectly, etc.), they may take responsibility and make whatever corrections are required at no charge, but most mistakes are due to the taxpayer not providing all of the relevant information. In that case (unless your tax preparer is being very generous), you’ll be on the hook for whatever costs result, including fees for your preparer’s services, along with potential taxes and penalties.

Myth: The IRS will call, email or text you if there is a problem.

The IRS only makes initial contact with a taxpayer via mail. If you have not already contacted the IRS and someone calls, texts or emails you and claims to be from the IRS, it’s a scam. They are trying to obtain your personal information, money—or both!

Even if the IRS does follow up with a phone call, they will never threaten to contact law enforcement if you don’t do what they say or demand immediate payment over the phone. They will never ask for payment via wires, crypto or gift cards. If any of these phrases are ever mentioned, they are immediate red flags you are speaking to someone who is trying to scam you.

Myth: Your tax refund is called your “return”.

This is more of a pet peeve that drives tax professionals crazy, but it’s an incredibly common mistake in terminology. If you don’t want to sound silly in front of a tax professional, keep these two points in mind:

– Your tax return is the documents you file with the IRS.

– Your tax refund is the money you get back from the IRS if you paid more than your actual tax due.

Myth: You have to be wealthy to get audited.

The most common triggers for an IRS audit are simple things like math mistakes, not reporting income the IRS knows about (i.e. not including income that appears on 1099s, W2s and other forms where income is reported directly to the IRS), claiming tax credits you don’t qualify for, and typos on personal information. The level of income on a tax return does not impact if a taxpayer will be audited or not.

An audit also looks a lot different than it used to. The vast majority of the time, you simply receive a letter from the IRS explaining the issue, showing their calculation for tax owed, and requesting that you either send payment or provide further documentation and explanation as to why you don’t agree with their findings. Gone are days when an IRS agent shows up at your door and looks at every line of your return, trying to find something wrong.

Understanding and navigating the tax code doesn’t have to be overwhelming. By separating myth from fact, you can make more informed decisions, avoid unnecessary penalties and better plan for the future. If you’re ever unsure about your tax situation, working with a qualified financial advisor or tax professional can help you stay on track and avoid surprises when tax season rolls around.