The Retirement Corporation of America

Save Money By Saving Paper

PAY ALL YOUR taxes for two or three years and you are going to accumulate a lot of paper. So how long are you supposed to save all that paper? The best answer is: Save documents as long as they are important for federal income tax purposes. Here are some guidelines:

•  Keep all tax records—especially those that show income or support a deduction or credit—for a minimum of three years from the deadline for filing that year's return. The IRS has that long to challenge your return. That also is how long you have to file an amended return claiming a refund.

•  To be safer still, keep your tax records for six years. That's how long the IRS has to challenge you if you failed to report income that was more than 25% of the income reported on your return.

For the record, if you file a false or fraudulent return—or if you do not file at all—the IRS can come after you at any time. The moral is pretty straightforward: Don't file a false or fraudulent return. Even if you can't pay your full tax bill, file a return anyway. The IRS will insist on its money and you will have to settle up—but you won't face jail for failing to file a tax return.

The bottom line is that it is best to keep tax returns for at least six years—just in case—and longer still if you have storage space. The IRS is not the most efficient agency in the world and it is operating with definitely outmoded computers. Who knows what mistake it might make in the future? You're in a better position to straighten out the confusion if you have saved your tax records.

Documents You Want to Keep Longer

Even if storage is at a premium and you want to dump most tax papers after six years, there are some documents you must hang onto. Examples include:

•  Form 8606. Remember that there are limits to how much you can earn and still make a tax-deductible contribution to your Individual Retirement Account. If you are above those income ceilings, you still can contribute to an IRA—but your contribution won't be deductible. Each year you make a non-deductible contribution, you must file Form 8606 along with your tax return. When you start withdrawing money from your IRA and start paying taxes on those withdrawals, the IRS will want to see Forms 8606 for every year in which you made a non-deductible contribution. If that means saving 40 years of Forms 8606, so be it.

•  Records that support the cost basis of assets. Cost basis is the original purchase price, plus the cost of improvements or extensions to the asset.

-  The cost basis of your home is what you paid for it, plus the cost of permanent improvements to the home over the years.

-  The cost basis of an investment in a mutual fund would be the purchase price of the original shares, plus the price of all additional shares acquired through taxable dividends and capital gains distributions over the years.

-  The cost basis of a stock would be the purchase price of the original shares plus all shares acquired over the years through the reinvestment of taxable dividends.

When you finally sell the asset, you may owe tax at the capital gains rate on the difference between your cost basis and what you sell it for. That makes it essential that you keep all documents that establish your cost basis.

•  For bonds, keep the original brokerage confirmation showing your cost.

•  For stocks, keep the original brokerage house confirmation showing your cost, plus all dividend reinvestment plan (DRIP) records showing how many of the shares came from the reinvestment of taxable dividends.

•  For mutual funds, keep the annual statements for every fund you own plus all trade confirmations that establish your cost.

Keep those records until you sell the stocks or bonds or funds shares. Then keep them for three years more after the filing date for the year just in case the IRS decides to challenge your return. Those records will show the purchase price of the original shares, plus how many of the shares you sold came from the reinvestment of taxable dividends and capital gains.

Your home is a more complex issue. The cost basis is the purchase price plus the cost of capital improvements—permanent improvements that add value to your house, as opposed to work that only keeps your house livable. A central air conditioner or a new bedroom that you add to the house would be a capital improvement. Having the house painted would not.

The Taxpayer Relief Act of 1997 excludes from taxation up to $500,000 in capital gains when a couple sells a house. Save all records that establish the cost basis of your home, even if you never expect the sale of the house to produce $500,000 in capital gains.

What Congress does one year, it can undo the next year. The need for new revenue down the road could blow that $500,000 exclusion right out of the water—leaving you stuck with capital gains on most, or even all, of your gain. Maybe you will never need to rely on those records to calculate your cost basis—but why take chances. Keep all invoices and cancelled checks for all improvements to your home until you sell the place. Then keep them for three years more, until that year's tax return is safe from challenge by the IRS.