The Tax Man Cometh -- income tax preparation

As unpleasant as it might be, this is a good time to start thinking about your 2006 tax return. I suspect that many of you don’t give much thought to your return. You turn it over to someone else to prepare and are happy if they tell you that you are getting a refund. While you are not alone (more than half of the 130 million returns each year are done by paid preparers), you make two critical errors when taking this course of action. First, having a clear understanding of your tax situation helps move to the path of financial independence – if you are not involved in preparing your taxes you miss a great opportunity to focus your financial goals. Second, getting a refund means that you overpaid – a clear sign that you are not managing your money properly.

So, that is the foundation for my unconventional recommendation that you prepare your own taxes this year. Yes you heard me correctly. I said you should complete your own tax return this year. The entire tax code is complicated but my guess is that your tax return is not. Also, there are several tax programs out there (TaxCut and TurboTax) that are inexpensive and do a great job at walking you through the process. Even if you have someone else prepare your return, I still suggest that you use one of these programs to prepare your return and then compare it with the “pro’s” version. There are great sales on these programs in January and you can usually find a copy for under $30. As an added bonus, you might find this software bundled with financial planning software (e.g., Quicken or Money) that you can use to start your budgeting.

If you are still not yet convinced, I will give you more to think about. Just because you pay someone to prepare your return, doesn’t mean it is correct. Last April, The Washington Post ran an interesting article that reports the results of a GAO study that revealed errors in 19 out of 19 returns brought to them to test the accuracy of work done by large chain tax-preparation firms. I encourage you to read the article yourself. http://www.washingtonpost.com/wp-dyn/content/article/2006/04/04/AR2006040401863.html

Why are there so many mistakes? Have you ever heard the term GIGO – garbage in; garbage out?. No matter how qualified the tax preparer is, if they don’t know your individual tax situation they can’t prepare the return properly. This means you have to provide them with the right information or rely on them to ask the right questions. You owe it to yourself to make sure that you at least understand what information has tax consequences so that you can provide it to the preparer. This is where TaxCut or TurboTax comes in handy. These programs walk you through a questionnaire that asks all the right questions (at least for all but the most complicated tax situations). I will leave these programs (or your preparer) to ask all the questions but I will provide you will the general categories that should be addressed:

• Who needs to file? – Your requirement to file is based on your income level ($8,450 for single filers) but it is important to note that even if you are not required to file you might want to file to recover any tax withholdings you made or receive credits that you may be entitled to (see below).
• What is your filing status? – There are four different filing status (married filing jointly, married filing separately, single and head of household) each of which has a different tax rate. Determining your status may not always be as easy as it seems and mistakes are costly (e.g., filing single when you qualify as a head of household)
• What are your exemptions? – Exemptions reduce your taxable income and are based on your marital status and dependents that you have (or if you are a dependent)
• What is your income? – Determining your income is not always as easy as it seems. For instance did you know that gambling winnings are income but gifts are not? You essentially need to identify any cash that you received during the year and assess whether it is taxable income or not.
• What are your deductions? – Deductions are items that can reduce your taxable income. You can take a standard deduction (a preset amount) or itemized (if you have the proper documentation). Itemized deductions fall under the general categories of i) medical, ii) taxes, iii) interest, iv) charitable contributions and v) other miscellaneous deductions such as casualty and theft losses and some employee expenses. Not all expenditures in these categories qualify as deductions so it is important to maintain good records and assess each expenditure independently.
• Are you eligible for any credits? Credits are very good as they reduce you tax liability dollar for dollar and, for certain lower-income filers, could result in you getting a refund from the government even when you paid no taxes! There are some pretty significant credits related to child care, education and the working poor. This is an area that paid preparers are likely to miss if they don’t know you situation.

There may also be an issue of the expertise of the preparer. The Washington Times article notes that these erroneous returns were prepared by individuals that are not “enrolled” agents. The GAO encourages you to seek out an enrolled agent (essentially a CPA or former IRS agent). While this might help some, it will be more expensive and still doesn’t solve the GIGO issue. You have to take charge by having enough of an understanding of taxes and your situation that you can assess the competency of the preparer. Let me challenge you by stating that if you can’t be bothered to do that, you are unlikely to ever be truly financially literate. It is a dirty deed that must be done!

I hope that I have inspired you to at least attempt to prepare your tax return. Even if you get started and then turn it over to a paid preparer, you will have become more educated on the topic. Gathering the information for your tax return will help you organize your financial paperwork to start a budgeting process. You may identify areas that you did not document and thus have a better understanding of what you need to do for next year. As I said before, budgeting is an iterative process that will improve over time.

As a final step I would ask you to determine what your effective tax rate was. This is determined by dividing your total tax liability (line 63 on Form 1040) by your total income (line 22 on Form 1040). This should be the basis for evaluating whether you think your tax burden is appropriate – NOT whether you get a refund or make a payment on April 15th. You should also use your tax return as a basis for adjusting your withholdings so that any refund or payment next year is as small as possible. Again, the software programs will help you with that.

I will leave discussing a broader issue that is a personal pet peeve of mine. This is a little off track but let me get on my soapbox for a minute. Because so few people actually pay attention to the taxes they pay, we have an uneducated citizenry that allows elected officials far too much discretion in collecting and spending OUR money. The U.S. tax system really is a clever design that serves to minimize discontent. Think about it. First, you have no choice but to pay as your employer withholds it from your paycheck. Then the rules are so complicated that few feel comfortable calculating your tax liability yourself. This leads to the likelihood that you have too much taken out of each paycheck. But when you get your refund you feel good about it! Since you don’t really know how much taxes you are paying, you tune out any discussion of taxes, leaving politicians to freely spend your hard earned money. Clever but totally absurd if you ask me. And yes, I am mad as hell about it and I am going to do something about it. What you ask? Why, I am going to get as many people focused on their own taxes as I possibly can! So go to it and take charge of your life!!