How long do you keep tax returns and related paperwork? If you look for guidance about recordkeeping from the IRS website, the answer seems straightforward—retain most tax-related paperwork for three years…perhaps six to seven years if you want to play it safe or in specific circumstances.
Unfortunately, that standard strategy is wrong, says our Bottom Line Personal tax expert Martin M. Shenkman, CPA, JD.
The advice about keeping tax documents is based on the statute of limitations for audits. Typically, the IRS isn’t allowed to audit tax returns after three years have passed, so you would think it is safe to dispose of those records at that point.
But: If you read carefully, you might have noticed a troubling word in that prior sentence—the word “typically.” There are numerous exceptions where the IRS can take action long after that three-year window. What’s more, IRS audits are not the only reason why tax-related documents might later prove valuable.
Here’s why it makes sense to keep tax-related documents much longer than the standard guidance suggests—ideally forever—along with a smart strategy for doing so…
Among the reasons why you shouldn’t dispose of tax documents after just three years…
The IRS has up to six years to audit your return if you underreport your income more than 25%. If you’re thinking, I don’t underreport my income, so I don’t have to worry about that, consider that even well-intentioned taxpayers occasionally overlook income when filling out tax forms or fail to notice when their tax preparers do so.
There is no limit as to when the IRS can audit your return if it suspects fraud. If you’re thinking, I would never file a fraudulent tax return, consider again that honest people sometimes do this unintentionally—a business partner or financial advisor could steer you into a scheme that turns out to be illegal, for example.
There’s no limit to when the IRS can audit if you file a gift-tax return that lacks “adequate disclosure.” Gift-tax rules are so complex that it’s very easy to fall short of this standard—even if you hire a professional tax preparer.
Paperwork related to the purchase or inheritance of assets or real estate might be needed decades down the road. When an inherited asset is later sold, paperwork documenting its value at the time of inheritance—will help establish your basis, and you’ll need that to calculate the capital gains taxes due. This paperwork should be retained until at least three years after the asset is sold, even if that’s an extremely long time after it was acquired.
Paperwork related to home improvements might be needed decades down the road. If you sell a home for more than you paid for it, you might owe capital gains taxes on some or all of your profit. One way to reduce that tax bill is by adding the cost of certain improvements that you’ve made to the property over the years to your purchase price—but you’ll need receipts, invoices or other evidence of the cost of those home improvements to do this. Perhaps you’re thinking, I’ll just use the capital gains tax exclusion to avoid paying any capital gains when I sell my home, consider that that there are limits and restrictions on that exclusion. Example: It’s capped at $250,000 ($500,000 if married and filing jointly) and isn’t adjusted for inflation, so it might be insufficient to shield you from all capital gains taxes…and you can use this exclusion only if the property has been owned and used as your primary residence for at least 24 months during the five years preceding the sale.
One more thing: Since the government has an unlimited time to come after you if it doesn’t think you filed, it is also a very good idea to keep proof of filing forever—the certified receipt for paper returns and IRS acknowledgment of an e-filed return.
Those are just the IRS-related reasons why it’s wise to hang onto many tax-related documents for much longer than three years. The paperwork that people think of as tax-related can become crucial many years down the road for other reasons as well, including…
Paperwork related to your possessions could help you make an insurance claim. Homeowners often are advised to make a video of all the possessions in their home so they can show their insurers what was lost if there’s a fire. But what if the insurer argues that that the home office furniture in the video looks like a discount-store knockoff, not a high-end product? Insurance companies are more likely to back down when policyholders can produce documentation of the value of their claims, such as receipts, in addition to video images. Similar: Such paperwork also could be useful if valuable items are lost or damaged by a moving company during a relocation.
Documents related to your earnings could help correct Social Security mistakes. The size of your monthly Social Security benefit is based in part on how much you earned and paid in payroll taxes during your career. But Social Security’s earning records occasionally contain errors or omissions. It will be easier to correct those mistakes if you can produce evidence of your earnings, such as old W-2s, 1099s or pay stubs. (An earnings record can be corrected at any time up to three years, three months and 15 days after the year in which the wages were paid or the self-employment income was derived. “Year” means calendar year for wages…and taxable year for self-employment income.) Similar: Documents showing your earnings history also could become useful if you suffer a disability and make a disability insurance claim.
Documents related to asset acquisition could be crucial in a divorce. If you received an asset as a gift or inheritance and/or you owned it before you wed, there’s a good chance that it’s your personal property, not marital property that should be divided if you divorce. But if you don’t have documents that show how and when you acquired the asset, ownership of the item may become a matter of dispute. Sometimes these records may be part of the backup you keep with your tax data.
Now, of course, the challenge is where and how to store all these documents.
