How Social Security Tax & Medicare Tax (or FICA) Work

“I want to find out who this FICA guy is and how come he’s taking so much of my money.” – Nick Kypreos (former professional hockey player).

Payroll taxes are based on your taxable (rather than gross) wages

The combined total of your Social Security and Medicare taxes are often referred to as “payroll taxes, ” “FICA,” or “FICA taxes.”[1]  The Medicare tax rate on wages is 1.45%.  Since 1990 the Social Security portion of FICA has been 6.2% of wages, but for 2011 only the rate was cut to 4.2% as a means to stimulate the economy.  Given this is the case, if your salary was $50,000 a year then it would be natural to assume that your monthly Social Security and Medicare taxes would be $235.42, which paystub breakdown is calculated as follows (assuming that the temporary 4.2% Social Security rate applies to this and the other examples that follow).[2]

How FICA Tax Works 1

What if I told you instead that your actual payroll taxes were $184.47, or $50.95 less than what you expected ($235.42 less $184.47)?  What accounts for the difference?  Exactly how is the Social Security and Medicare tax breakdown on your paycheck calculated?  To answer that the most important thing you need to understand is that Social Security and Medicare taxes are not driven by gross monthly wages, but by your taxable wages.  This is illustrated by the following example, which shows how the $184.47 of payroll taxes referred to above was calculated.[3]

How Social Security Tax Works 2

Again, a key thing to take away from this example is that by default your gross wages or salary (the $4,166.67) is the starting point for calculating your payroll taxes, but there certain things which can either increase or decrease your taxable FICA wage base.  In the example above you received $15 in non-cash taxable fringe benefits, and that served to increase your FICA taxable base.  On the other hand, your health insurance premiums and “FSA” (or “flexible spending account”) contributions served to decrease your FICA taxable base.  Thus, after taking into account all of the adjustments shown above, your taxable FICA wage base decreased from $4,166.67 (your gross monthly wages) to $3,265.00.

Why calculate Social Security and Medicare taxes separately?

If you compare the Social Security and Medicare tax calculations above you’ll notice the only difference between the two is that the tax rates are different (4.2% vs. 1.45%).  If that’s the case then why calculate the two taxes separately?  Why not just take your taxable FICA wages ($3,265.00) and multiply it by 5.65% (4.2% plus 1.45%) to arrive at your total FICA taxes of $184.47 ($137.13 plus $47.34)?  There answer is that will actually work for most people.  However, there are two reasons you need to be able to calculate your Social Security and Medicare taxes separately.

  1. The two taxes almost always appear on your paystub as separate figures rather than as one combined FICA tax, so it’s important that you know how to check each of them individually.
  2. If your taxable wages happen to be in excess of $106,800 (congratulations!) then it throws the math off, because wages in excess of that amount are exempt from Social Security taxes whereas all wages are subject to Medicare taxes.[4]

Verify that your payroll taxes are calculated correctly on your paystub

Now that you understand the principles behind calculating Social Security and Medicare taxes, pull out your last paystub and verify that your own FICA taxes are being calculated correctly.  If you’re able to successfully do so then feel free to skip to the “Summary” paragraph at the end of this article. If, however, you’re still having trouble verifying that the Social Security and Medicare taxes on your own paystub are being calculated correctly then you first need to determine what your employer is using as your taxable FICA wage base.  You do that by dividing the Medicare taxes on your pay stub ($47.34 in our example) by the Medicare tax rate (1.45%), illustrated as follows.[5]

FICA Tax or Medicare

Do you see what you’ve done?  Using the formula above you’ve mathematically determined that, according to your company’s payroll department, your taxable Medicare wages are $3,264.83.  That’s significant because remember, by default, Medicare taxes are based on your gross wages.  Therefore, if your gross wages ($4,166.67) are not equal to your taxable Medicare wages ($3,264.83) then it means they’ve have been adjusted for payroll tax purposes, and the amount of the adjustment can be calculated as follows.


So how do you account for this difference of $901.84 between your gross monthly wages and your taxable Medicare wages?  Referring back to earlier illustrations in this article, you will find the following:

Social Security Tax FICA Tax

What this shows is that after you take into account payroll tax (or FICA) deductions related to your health insurance and flexible spending account contributions, you can fully explain the difference between your gross wages and your taxable Medicare wages except for a fairly small difference of $14.83.  Not bad.  But wait, if you think about what you read in the previous article about non-cash fringe benefits then does that give you an idea of what the difference could be?  It’s very close to the $15 of taxable fringe benefits that you received (see above), and when you add those back then your reconciliation is only off by 17 cents.[6]

How FICA Tax Social Security Tax Work

In summary, you can verify that your Medicare tax ($47.34) is correct by verifying that your Medicare tax base ($3,265.00) is correct.  In addition, once you’ve verified your Medicare tax base, you can use the following method to verify that your Social Security taxes are also being calculated correctly.[7]

How FICA Tax Social Security Tax Work


So what’s the point of this whole exercise?  After all, isn’t your company’s payroll department supposed to ensure that your Social Security and Medicare taxes are being calculated correctly?  Of course they are, but if you’re serious about managing your money then you shouldn’t just blindly fork over $184.47 ($137.13 in Social Security and $47.34 in Medicare taxes) to the government every month unless you know why.  No, if you’re serious about managing your money then you’ll make the effort to independently verify that your payroll taxes are being calculated correctly.  If you’re unable to do so then contact your employer’s payroll department and have them walk you through how they came up with the numbers on your paystub.

[1] FICA stands for “Federal Income and Contributions Act,” which is where the federal government derives its authority to levy payroll taxes.  Source: Internal Revenue Code Section 3101.

[2] For purposes of this example and the ones below it’s assumed you are paid on a monthly basis.  However, the same principles apply if you are paid bi-monthly, weekly, etc.

[3] The figures in this example are drawn from my introductory article on how to read checks.

[4] The $106,800 Social Security wage base is accurate for 2017 (it’s adjusted annually for inflation).  See  For more information how to handle high wages and other special issues related to Social Security tax calculations click here.

[5] Why is it important to use the Medicare rather than the Social Security tax rate to determine your taxable FICA base?  The reason is that Medicare doesn’t have a taxable wage ceiling, so the formula will work every time.  On other hand, because the Social Security wage base is capped at $106,800 (2011) then the formula won’t work if your wages happen to be in excess of that amount.  If you find this confusing then just remember that it boils down to this: use the Medicare tax rate of 1.45% in the formula!

[6] You don’t need to contact your payroll over an amount as small as 17 cents; it’s just a rounding difference.

[7] Note that if your taxable FICA wages are in excess of $106,800 (based on 2017 figures) then your Social Security taxes for the year should be capped at $4,485.60 ($106,800 times 4.2%).

How to read checks pay stub meaning

How To Read Checks – Pay Stub Explained

Understand Pay Stub Meaning & How To Read Checks

Some of your most expensive bills are in your paycheck

In order to manage your money effectively you need to have a clear understanding of all of your expenses.  What many people either forget or don’t realize is that some of their most expensive bills don’t show up in the mail, but in their paycheck!  For example, if your salary is $50,000 a year and you’re paid once a month then your gross monthly wages (or salary) would be calculated as follows.[1]

Pay Stub Meaning & How To Read Checks

What this means is barring any complicating factors, you should expect to receive exactly $4,166.67 each month.  But of course things are not that simple because, as anyone who has ever gotten a paycheck knows, there are complicating factors!  As it relates to our example, what if I told you that instead of your take-home pay (meaning the amount of money that actually made it to your bank account) being $4,166.67, it was only $2,482.11?  What’s going on here?  How can your net pay be $1,684.56 less than what you earned, an amount that’s over 40% of your total paycheck?  In short, what financial sharks devoured massive chunks out of your monthly earnings before they ever even got to your bank account?!?

How To Read Checks – Sample Paycheck Breakdown

Based on the figures above, the following breakdown accounts for the $1,684.56 reduction in gross pay of $4,166.67, to arrive at a net paycheck of $2,482.11.

Gross Wages (or Base Monthly Salary) $4,166.67
Less: Health Insurance ($350.00)
Less: FSA – Medical ($166.67)
Less: FSA – Dependent Care ($400.00)
Less: Retirement Plan Contribution ($416.67)
Less: Social Security ($137.13)
Less: Medicare ($47.34)
Less: Federal Income Tax ($65.83)
Less: State Income Tax ($105.92)
Less: Disability Insurance ($30.00)
Less: Company Deductions ($45.00)
Add: Reimbursements $80.00
Equals: Net (or Take-Home) Pay $2,482.11

It’s important to note here that not everything that’s taken out of your paycheck is bad.  For example, the $416.67 contribution to your retirement plan will certainly help you in the future, but you also need to take into account that it’s $416.67 less in the current month that you’ll have to pay the bills, cover day-to-day expenses, and do other things you would need or like to.

Know where every penny of your paycheck is going and why

Fully understanding the breakdown of your paycheck is one of the great mysteries of the known universe.  To cut through all the complexity, my approach to paycheck analysis boils down to this: if your employer has agreed to pay you $4,166.67 a month then you should expect them to deposit exactly that much each month into your bank account, and if you get any less ($1,684.56 less in our example!) then you should figure out where every penny went and why.  The purpose of this article is to give you with a starting point to do just that, by providing you with links to relevant paycheck-related information, examples, and insights (see below).

Related articles and information

To continue this series and read the next article on how to read your paycheck.   Also, you can click on any of the links in the sample paycheck breakdown above if you want to go straight to information on a specific area of your paycheck.  Finally, you can also refer to other information on taxes.


[1] According to government statistics, the median income of a household in the United States in 2018 was $61,372 (see  While that figure is a bit dated, rounding it to $60,000 to make my examples easier to follow.

Taxable Wages vs Gross Salary or Wages

The Taxable Wages vs. Wages (or Salary)

Gross taxable wages is a major component of paycheck calculations

Your gross taxable wages drives much of what is going on as far as your paycheck is concerned.  For example, it’s the starting point for determining your Social Security and Medicare taxes as well as your federal and state tax withholdings.  But determining your gross taxable wages should be easy, right?  After all, if your salary is $50,000 a year and you’re paid once a month then it would be natural to think that your gross monthly taxable wages would be calculated as follows:[1]

However, what if I told you that your gross monthly taxable wages were actually $4,181.67, or $15 higher than $4,166.67?  What’s going on?  Where is the extra $15 coming from? The answer is that $4,166.67 is equal to your gross monthly wages, not your gross monthly taxable wages.[2]

Non-cash fringe benefits

What’s the difference between your gross monthly wages ($4,166.67) and your gross monthly taxablewages ($4,181.67)?  The answer is that sometimes a company will provide you with non-cash fringe benefits that are taxable.  A non-cash fringe benefit (or simply a “fringe benefit”) is something of monetary value that your employer provides to you in addition to the pay you receive.  If a non-cash fringe benefit is taxable the law requires your employer to add an amount to your gross income equal to the value of benefits you receive.

For our example we’ll assume that your employer has a policy of providing each employee with life insurance coverage equal to three times salary, which in your case comes to $150,000 (your $50,000 base salary x 3).  This exceeds the $50,000 tax-free amount allowed under current law by $100,000, and that extra life insurance coverage would cost $15 a month if you bought it on your own.[3]  And from the government’s perspective that’s exactly the point – it’s as if your employer paid you an extra $15 a month which you then used to purchase life insurance.  As a result, the law requires your employer to add an extra $15 to your gross income each month (or $180 a year) so that it will be included in the taxable wages you’ll report on your income tax return.

Note that in some cases non-cash fringe benefits are also non-taxable.[4]  For example, if a company stocks drink machines with free sodas that any employee can get just by pressing a button then that likely qualifies as a non-cash fringe benefit that’s also non-taxable.  In other words, you’re able to get sodas without for paying for them and you don’t have to count the value of the sodas you consume as taxable wages on your income tax return.  In short, non-cash fringe benefits that are also non-taxable are a way for you to have your soda and drink it too.

Understanding income reporting on your paystub and Form W-2

Now that you know the distinction between gross wages and gross taxable wages you’re in a better position to understand your paycheck.  For example, gross wages ($4,166.67 based on the figures above) on your pay stub should be labeled something along the lines of “Salary,” “Regular Salary,” or “Wages.”  Likewise, your gross taxable wages ($4,181.67 based on the figures above) should also appear on your paystub and be labeled something like “Current,” “Current Taxable Wages,” “Taxable,” or “Taxable Wages.”

Using the principles discussed above you should also have a better understanding of your W-2, the tax form that your employer mails to you at the beginning of each year (e.g. January 2011) telling you how much you need to report in wages on your April 15th tax return for the year that just ended (2010).  So in our example would you expect your taxable wages for the year to be $50,000, right?  No!  Remember, that’s just your salary.  Your taxable wages in box 1 of Form W-2 should be $50,180, equal to your $50,000 base salary plus $180 of non-cash taxable fringe benefits relating to your life insurance coverage ($15 a month x 12 months).  Also, the $180 value of your non-cash taxable life insurance fringe benefit should be separately reported on your W-2 at line 12.

Why knowing how to calculate your gross taxable wages is important

So is all of this small potatoes?  After all, is it really the end of the world if you don’t understand why your taxable income is $15 higher per paycheck than your salary?  No, $15 of extra taxable income a month (which would translate into $2-$4 of extra tax) probably shouldn’t rate high on your list of things to lose sleep over.  However, what if you had more significant non-cash taxable fringe benefits such as the use of a company car, your company paid club dues on your behalf, or you got to take a personal trip on the company plane?  In such cases the value of your non-cash taxable benefits could be significant, and if that’s not something you take into account then you could be in for a nasty surprise when you get your tax bill.

But what if you’re like most regular people you don’t get a company car or have the opportunity to jet around the country in the company plane?  What if all you ever have is that $15 or so difference a month between your gross wages and your gross taxable wages?  Would it really be that big a deal not understand where that difference came from?  As I said before, on the surface it wouldn’t seem to matter very much.  However, in my experience the difference in confidence between those who sort of understand their finances and those who really understand their finances makes a big difference in their ability to make confident, sound, and decisive financial decisions.  And as further articles will show, if you don’t understand the difference between your gross wages and your gross taxable wages then you’ll never fully grasp what’s going on with the rest of your paycheck.

[1] The figures in this example are drawn from my introductory article on how to understand your paycheck.

[2] This example assumes you’re paid once a month, but the same principles apply if you are paid bi-monthly, weekly, etc.

[3] Source: Internal Revenue Code Section 79.

how do taxes work

An Overview of How Taxes Work

An Overview of Paying Taxes, Filing a Return, and Getting a Refund

Form 1040 is used to calculate your income taxes

The purpose of a tax return (such as IRS Form 1040) is to calculate the total Federal income tax you owed for the prior year.

While a tax return is used to calculate your tax, it is not necessarily used to paytaxes.  Instead, most regular people pay Federal (and state) income taxes over the course of the year through their paychecks.  To verify this, check your most recent pay stub to see how much Federal tax is being taken out of each pay period.

“Federal income tax” does not include Social Security and Medicare

In examining your pay stub, it’s important to clarify that while Social Security and Medicare are also taxes imposed by the Federal government, they are not the “Federal income taxes” that are calculated on IRS Form 1040.  Rather, Social Security and Medicare are separate taxes known as “FICA” or “payroll taxes.”  The good news is that you don’t have to file any tax returns to report and pay Social Security and Medicare taxes.  The bad news is that your employer deducts these taxes directly from your paycheck and pays the money to the IRS on your behalf.  Your employer also files payroll tax returns on a combined basis for all of its employees (IRS Form 941).  In summary, you don’t have any tax filing responsibilities when it comes to payroll taxes, but you do have to stick you chin out and get socked by Social Security and Medicare tax withholding.

Your tax return for the prior year is due by April 15th

Safe Harbor 401k Tax BenefitsReturning to Federal income taxes, near the end of January of each year you should get a Form W-2 from your employer.  This is a summary of how much income you received from your employer during the prior year, as well as how much Federal (and state) income tax they paid to the government on your behalf (Form W-2 also summarizes how much Social Security and Medicare tax you paid in over the course of the prior year).

Using the information from your W-2 (and other sources), you complete your prior year tax return by April 15th of the current year.  There is no reward or penalty for filing your tax return before April 15th but, again, the final due date is the 15th (unless it falls on a weekend, which makes the deadline the following Monday).

Upon completing your tax return you will finally know for sure how much tax you owed for the prior year.  You will then compare that with how much you actually paid in through your paycheck.  If you paid in more than you actually owed then you will be due a refund from the IRS.  On the other hand, if you owed more than you actually paid in then you will have to include a check payable to “U.S. Treasury” with your tax return for the balance due.

An example of the tax filing process

To illustrate the concepts above, let’s say that during 2018 you were paid monthly, and you had $100 of Federal tax deducted from each of your paychecks.  That means over the course of the year you paid a total of $1,200 in taxes to the Federal government through your paycheck, and the Form W-2 you receive at the end of January 2019 from your employer confirms that’s the case.

Prior to April 15th, 2019 you complete a 2018 IRS Form 1040 in order to calculate how much tax you owed for the prior year (2018) based on your income and other factors.  After completing all of the appropriate forms and schedules, it turns out that your actual Federal tax liability for 2018 was $700.  As a result, because you paid in ($1,200) more than you actually ended up owing ($700), you’ll end up getting a tax refund from the IRS of $500.

Tax audit IRS

5 Problems With A Federal Income Tax Audit

Federal Income Tax Audit – What does it mean to get audited?

My 2016 Federal tax return was recently audited by the IRS, and I can’t say that I liked it.  Well, that’s pretty obvious, isn’t it?  After all, when it comes to audits, what’s to like?  But aside from the obvious displeasure I had in getting audited in the first place, what problems did I encounter, and what does that mean to you?

Before I answer those questions, let me first clarify what it means to get audited.  Does it mean a pair of men in dark suits, sunglasses, and those little ear devices show up at your doorstep in the middle of the night, or does it mean to be summoned to the nearest IRS office?  While the latter is still a possibility, that’s really not how most audits happen these days.  Instead most audits now are “correspondence audits” (otherwise known as “desk audits”), or a letter in the mail from the IRS stating that they disagree with a specific part of your return, informing you of a corresponding adjustment (which increases your tax bill or decreases your refund), and providing you with information enabling you to contact them if you disagree with the adjustment.  And it’s this kind of audit – a correspondence audit – that I was subjected to. And again, aside from having to devote time and energy to dealing with an audit in the first place, I had 5 problems with the process.

Problem #1 – The IRS will automatically reduce your refund

After completing and filing my 2016 Federal tax return I was due a refund of $1,250, which I requested to be deposited electronically in my bank account.[1]  As a result, you can imagine my disappointment when I only saw a refund of $750 hit my bank account, a full $500 less than I was expecting.  I got out a copy of my tax return and flipped through it.  As far as I could tell, everything looked correct.  And yet there I was, with $500 less than I was expecting.  To make matters worse, because the IRS already had my money I was now forced to deal with their bureaucratic machinery if I wanted it back.  Said another way, if I took no action then my $500 was gone forever.

This situation illustrates an important financial principle.  Whenever you’re in any kind of financial dispute, you want to be the one holding the money if at all possible.  What does that mean as far as filing your tax return goes?  Everyone, it seems, loves a tax refund.  And I admit, it’s nice to get that refund check in the mail (or electronically deposited as the case may be), but it’s really not the ideal tax filing strategy.  The reason is if the IRS calculates a different tax liability than you then they’ll automatically reduce your refund, and the impetus will then be on you to get your money back.  As a result, the sweet spot is to owe $1 upon filing your federal tax return.  Why?  Because the out-of-pocket cost of filing your tax return is low (meaning you just have to send it in with a check of $1 rather than having to suddenly and unexpectedly come up with $1,000) and, if the IRS disagrees with your tax calculation, then they’ll have to bill you.  That wouldn’t be good news, of course, but at least you would still be holding on to your money as you worked things out with the IRS.

Problem #2 – The reasons the IRS provides for reducing your refund can be VERY vague

Naturally I wanted to know why I got less of a refund that I expected.  With no correspondence from the IRS yet (remember, at first I only saw that less hit my bank account than I expected), I went to the IRS website ( and clicked on “Where’s My Refund” to find out more specific information on what was going on.

What a disappointment.  Instead of seeing a line-by-line comparison along the lines of, “Here was your tax calculation, here is where our tax calculation was different, and this is the difference,” the only information that was given was a vague statement that the adjustment was related to “Self-Employment Tax.”  Once again I looked at a copy of my 2016 Federal tax return, this time focusing on the self-employment tax-related sections, and I still didn’t notice any errors.  A bit frustrated at this point, I now realized that I had to wait on a formal correspondence letter from the IRS that would provide more details.

When the letter finally did come it was also a disappointment, telling me little more than the information I had gotten from the IRS’s website.  The one page letter said, “We believe there’s a miscalculation on your 2016 Form 1040, which affects the following area of your return: Self-Employment Tax.  We made changes to your return that correct this error.  As a result, you are due a refund of $750 (again, $500 less than the $1,250 that I was expecting).”  There was a little more information in a section titled, “Your tax calculations,” but it was just top-level information from Form 1040.  In summary, given the fact that the IRS clearly performed a specific calculation to come up with an adjusted refund amount for me ($500 less than I was expecting), it was disappointing that that they didn’t give me enough information on what they had done to clearly understand what was going on.

Problem #3 – You’ll be the one that has to do the heavy lifting

Since it was obvious that no more information from the IRS was forthcoming, I had no choice (if I wanted my $500 back) but to roll up my sleeves and get to the bottom of things.  When I finally got a block of time (something which doesn’t always come easy for a regular person), I used the information on my tax return and my supporting documentation to build a spreadsheet analysis of the IRS’s adjustment.  My objective was to figure out what calculations the IRS used to arrive at my adjusted refund.  Once I knew that, I could make a judgment on whether they were correct or whether my tax return as originally filed was correct.  After about an hour and a half or two of sustained effort I finally determined how the IRS arrived at their adjustment, and when I compared it to my own figures it was clear to me that I had been right all along.  While that was good news, I didn’t exactly feel like celebrating.  After all, I had already put in a good deal of time, focus, and energy into determining what was going on, but I still had to deal with the IRS directly in order to get the remaining portion of my refund back, and that’s something that can be difficult and time-consuming as well.

Problem #4 – You’ll be at the mercy of the IRS in getting in touch with someone who can help you

In responding to the IRS I essentially had 2 options.  I could write them or I could call them (both an address and a phone number were provided for in their correspondence audit letter, otherwise known among tax professionals as an “IRS notice”).  After giving it some thought I decided to call.  Why?  First of all, I had done my calculations, so I knew exactly what the problem was and what the IRS needed to do to fix it.  Second, since that was the case, I knew that if I got the right person on the phone then I could get my issue resolved in short order.  Finally, I figured that if a phone call didn’t work the way that I hoped it would then I could always send a formal letter to the IRS using the address that they provided.

I was fortunate when I called that I got an IRS employee who was reasonable, helpful, knowledgeable and responsive.  I explained my issue to her and she listened to what was going on, giving me the benefit of the doubt.  To some degree I believe her attitude had to do with the fact that I was prepared and knew exactly what I was talking about, and I was careful not to complain.  In any case, shortly into our conversation she asked me to fax her my tax calculations, which I did.  Upon examining them she agreed the problem was on the IRS’s side and, after further investigation, she realized it was because an IRS employee had incorrectly keyed my return into the system.  As a result, she agreed right then and there that my return was correct as originally filed, and she authorized the remaining portion of my refund ($500) to be wired to my bank account within a few business days.  And, fortunately, that is indeed what happened.

As you can see, while my audit took some time and effort to resolve (even though I was right all along), it did end up working out without an excessive degree of difficulty.  However, an important factor in things going as smoothly as they did was because I was fortunate to have gotten ahold of someone at the IRS who was both competent and helpful.  While that is often the case, sometimes it is not.  The IRS is a huge, bureaucratic government agency, and unfortunately I’ve run into some hardheads over time.  When that happens – even if you’ve got your ducks in a row – it can be tough sledding.  And if that happens then what do you do?  Well, that’s when things get hard, because you have to either keep dealing with a difficult person, call back and try to get someone else, or respond in writing.  With any of those choices the resolution of your situation can stall as you find yourself getting stuck in the bureaucratic mire of the IRS.

Problem #5 – It’s unlikely that “regular people” will be able to resolve many tax problems on their own

Look, I’m a regular person in many ways.  I can’t tell what that rattle in the car means, I don’t know why my rose bush is dying, and when my TV remote starts acting weird I don’t really know what to do.  But when it comes to income taxes (and personal finance in general) then I’m in my element; that’s what I do, and that’s what I’m good at.  So even though things worked out well for me as far as my audit was concerned, as I said above, I think in large part it had to do with the fact that I’m a tax professional who knows my way around the system.  In short, I don’t think a “regular person” (as far as taxes goes) could have resolved an audit similar to mine, at least not without a lot more time, pain, and/or expense.  And specifically what would a regular person’s options have been in a situation similar to mine?  Here they are, and none of them are attractive.

  1. Spend lots of time – The first option would have been to spend substantially more time than I did (remember, I’m a tax professional).  But unfortunately time alone is not enough to resolve your tax problems if you don’t really know what you’re doing any more than I can make my TV remote work without understanding the technology behind it.
  2. Spend lots of money – Another alternative would be to hire a tax professional to help you, but that could cost you anywhere from $75 to $200 an hour.  As a result, you could lose a massive chunk of your refund before you ever see any money…and that’s if you’re right in the first place!  If you’re tax return turned out to be wrong then you will get hit with the double-whammy of by spending money on professional fees only to confirm that you do indeed owe the IRS more money.
  3. Do nothing – Finally, if dealing with the IRS seems like it’s going to be too expensive, bewildering, and/or intimidating relative to the time and/or money you would have to put into it then the final option would be to just eat the $500 assessment and write it off to bad luck.

In summary, while I won’t be happy about it, you can drop a tax professional like me in the middle of an IRS-created wilderness with very little to go on and I’ll find my way out.  But unless the IRS does a better job of providing clearer, more understandable guidance in their correspondence audits then regular people stand to lose a lot of money, either in tax assessments or professional fees.  And that’s precisely the kind of time-consuming, stressful, unexpected, and expensive situation that regular people need all the help they can get as they deal with all of the other pressures of day-to-day life.

What is the solution to successfully dealing with IRS audits?

Given the significant problems you can encounter with an IRS audit, what should you do?  There are no easy answers, but you basically have two alternatives.  First, you can have your tax return prepared by a competent tax professional who will stand behind their work in the event that you are audited.  Second, you can roll up your sleeves, learn how to deal with your own tax situation, and then take care of your problems yourself.

I believe the latter – tax self-sufficiency – is the best route to take.  Taxes can be a significant expense, so it’s unwise to be totally unaware of how they’re calculated if you can at all help it (register with this website or like it on Facebook for more guidance from future articles!).  Finally, even if you find you cannot handle a certain tax issue yourself, the efforts you do make to understand it will almost certainly pay off since it will better enable you to make informed decisions based on the guidance of your tax advisor.

[1] Note that I have changed the actual amounts to easier illustrate the principles outlined in this article.