You might be surprised to hear this, but the truth is you should retain tax records much longer than the IRS suggests. As you’ll see in a minute, your tax returns serve many purposes. And those documents can come in handy long after the tax man has gone his merry way.
What The IRS Says About Tax Record Retention
The “Man” suggests that most individual taxpayers should hold on to their tax returns for three years. Specifically the IRS says:
“Generally, the IRS can include returns filed within the last three years in an audit. Additional years can be added if a substantial error is identified. Generally, if a substantial error is identified, the IRS will not go back more than the last six years.”
In plain English, this means if you keep your nose clean and avoid red flags that raise the risk of an audit, the IRS usually doesn’t go back further than 3 years. However if they discover a material error, the Revenue Service might go back 6 years. (Notice that the language doesn’t say the IRS can’t go back further than 6 years. My guess is that if you try some sneaky stuff on your return the IRS will start getting tough and go back even further.)
Why Keep Tax Records Longer Than The IRS Suggests
Keep in mind that your tax return summarizes your entire financial life. And you might need the information contained in that data vault for purposes other than an IRS tax audit. Let’s look at a few examples.
First, your return records how much you paid for significant assets. You will need that info to calculate cost basis when you sell the asset in the future – and your tax return might provide the only clue you have as to what you paid for it. This is especially true if you own a small business and buy depreciable assets. And it is certainly the case as it relates to investments.
It’s true that investment custodians are forced to report your cost basis if you sell an equity or mutual fund if they have the information. But let’s say you bought the investment at Schwab and sold it after you transferred the account to Fidelity. In that case Schwab won’t be able to provide an accurate cost figure. For that you’ll need to refer back to your old tax return.
If you find this post interesting, please read my post on How To Organize Your Important Financial Documents.
The second reason to hold on to your tax records is to validate pension and Social Security benefits. Let’s say you request your Social Security benefits statement and discover an error. (I know it’s hard to believe that a government agency could possibly make a mistake but I have heard that it happens once in a blue moon.)
Let’s say the Social Security Administration report indicates that you failed to work during a given year but you know you did. If you have your 1099 from that period, you can “stick it to the man” big time and get your proper benefits. Otherwise, you might have to work additional years in order to qualify for the Social Security benefit.
And that’s not all. Your tax return can come in very handy when it comes to proving you made IRA contributions and/or took distributions. And when it comes to non-deductible IRA contributions, your tax return might be the only thing standing between you and a 30% tax bite on withdrawals.
Do You Have To Keep Physical Records Forever?
While it’s important to be able to lay your hands on the information contained in your tax return, you don’t really have to hold on to all that paper. I always ask my CPA to send me a digital tax return and he is only too happy to oblige. In addition, I scan all my 1099’s and year-end investment statements.
Of course I password protect these documents so no bad guys have access. By taking these steps I have instant access to my financial history and I don’t have to waste my prize shoe boxes by filling them up with those wretched tax papers.
I suggest you follow suit. Invest in a scanner and keep all your tax records digitally – but keep them forever. You may never need the information. But it’s nice to know it’s there if you do.
Have you ever had to access old tax information? Did you have the data when you needed it?
JC Webber III says
I don’t get how you can go back to an old tax return to discover what you paid for an asset. Who reports asset purchases on their tax returns if you are still holding them?
Neal Frankle, CFP ® says
Financial assets are listed on the 1099s JC.