Make smarter financial decisions – using a computer to track taxes year round
David Wood, a Pittsburgh software developer, credits tax-planning software with helping him plan for a career change. When his brother Steven called with an appealing business offer, David didn’t only consult his wife and his inner voice; he also asked his computer. Steven had a strong idea: He owned a communications company, and David was a software expert. Together they could develop a voice-mail system that might turn a tidy profit down the road. But David, who is employed full-time at the Software Engineering Institute at Carnegie Mellon University in Pittsburgh, had just spent a year developing a sideline computer consulting and training business. From the start it had been profitable, and if he decided to tackle his brother’s project, with its higher equipment costs and longer lead times, he would have to give up the consulting. He wasn’t sure he could afford the switch.
David put all of the relevant figures into his tax-planning program, if:X Personal Tax Analyst (Softview), and found the answer he needed. The amount he would save in taxes (by earning less on consulting fees and spending more on equipment) would buy him the time-and the equipment-he needed to go into business with his brother.
Now David is planning to quit his day job in a couple of years. And he uses Personal Tax Analyst regularly to make sure he’s still on course. SMART BUSINESSES PLAN TO SAVE
The Woods’ story is a good example of how tax planning can go beyond the quarterly calculation of estimated taxes. But it needn’t be the only way. You don’t need a new business, or even the latest in tax-planning software, to monitor your tax picture throughout the year.
And monitor you should. By keeping an eye on your taxes you can avoid the April anxieties, run a more orderly business, and probably save money on your bottom line. At the very least, you’ll get your records in order early. The beginning of the year is the best time to establish a tax-planning system. Do a mock return for the previous year as early as possible, and it will give you a good indication of what your final estimated-tax payment (due January 15) should be. It will also give you an idea of whether you handled last year’s business matters, such as equipment purchases and retirement investments, to gain full tax advantages. And it will get you started early at what should be a habit for 1991 and beyond: taking a regular look at your taxes and using that knowledge to plan business decisions effectively. Here are several ways that year-round tax planning can save you money: Pay the minimum estimated tax. You can avoid Internal Revenue Service penalties if you pay the same amount in estimated taxes as you paid in taxes the previous year, or pay 90 percent of the taxes you will owe this year. But if last year was a horrible year and this year is a good one, you’ll still end up with a hefty tax bill in April. If this year is poor and last year was great, you’ll end up providing Uncle Sam with an interest-free loan-and possibly strapping yourself. Better to recalculate regularly in order to keep payments in line with what you really expect your taxes to be. If you’re disciplined, you can do this calculation and then send the IRS only the minimum amount needed to avoid a penalty. Keep the rest of your tax payments in an interest-bearing savings account or money-market fund. invest your equipment deductions. Small businesses are allowed to deduct up to $10,000 a year in equipment purchases without depreciating them over time, according to Indianapolis financial planner F. David Bixler. This is called the section 179 deduction, but you’re not allowed to take it if it results in a loss. The earlier in the year you are able to estimate your annual earnings, the sooner you’ll be able to plan your equipment purchases.
Bixler says he likes to plan purchases with his clients in January or February, so they can spread out their deductible expenses over the year.
Planning means you’ll know before you buy. You’ll know, for instance, if that laser printer will put your equipment purchases over the $10,000 limit or over the amount of money your business earns. If either is the case, says Queens, New York, tax consultant Irvin Feldman, you can defer buying the equipment until next year and lease it until then. There’s no limit on leasing deductions, Feldman points out, unless you are leasing a car, which does not fall under the section 179 deduction as computers do.
If you plan to buy so much equipment that you exceed the $10,000 limit, says Washington, D.C., CPA Patricia Drolet, you may want to time those purchases for early in the year-the depreciation write-off is larger if you put the equipment in service in the first or second quarter.
Shelter income in retirement accounts. Business owners are allowed to shelter up to 20 percent of their taxable business income in Keogh or SEP-IRA retirement accounts, depending on the kind of account they establish (see my Finance column this month for more on retirement plans). You need to know how much you will make in order to know how much you can start stashing away in your retirement account. As Bixler points out, the earlier in the year you start funding your plan, the more tax-free interest it can accumulate.
Make the most of the business-tax rate. People who own their own businesses will pay 15.3 percent in Social Security taxes on their 1990 business income and a similar, as yet undetermined, amount on their 1991 earnings. Even though half that payment will be deductible from personal taxes on the 1040 form, it’s hefty enough to push your combined business-tax rate well above your personal-tax rate. Deductions within your business are worth more than deductions outside of your business. And income in your business is worth less than income outside of your business. So if you’re an employee as well as a sole proprietor, and you can legally move a deduction from Schedule A to Schedule C, do so, because it will be more valuable there. HOW TO COMPUTE YOUR OWN TAX PICTURE
There are four basic ways to use your computer for tax planning. You can: * Keep running records on a money-management program like Managing Your Money, which has a tax-estimating function. * Plug new numbers into last year’s tax-preparation software. * Employ a specialized tax-planning program like Personal Tar Analyst. * Devise your own tax-calculating spreadsheets.
Each method has advantages and disadvantages. SOFTWARE AS MONEY MANAGER
Conroe, Texas, real-estate agent Don Rickwalt’s estimated taxes are only a keystroke away; he keeps a running tally of his income and expenses in Managing Your Money, a personal-finance package. In response to a single command, MYM forecasts annual taxes using year-to-date real figures and Rickwalt’s own projections for the remainder of the year.
Clearly the advantage of Rickwalt’s approach is convenience. It doesn’t take him a long time or a new program to get a rough estimate on taxes, as long as he keeps up with the budgeting throughout the year. And he doesn’t have to key in his figures twice, as he might if he were to use a tax-planning program that was separate from his accounting software.
Even though his commission-based income is sporadic, he always has a rough tax estimate available. He can tell “by pushing one button” if he has room in his budget for equipment, if he’s saving enough in his retirement plan, and how much he needs to be putting away for estimated taxes.
But this approach doesn’t make it easy to do what-if tax planning. If he wants to measure the tax effects of different purchases, sales, and investments, Rickwalt must go back to his original entries and insert or delete the activities he’s planning to change. Then he gets an estimate on his taxes and compares those results with the estimated taxes on his existing budget. Finally, he has to go back and wipe out the pretend calculations so they don’t skew his real accounting for the year. Every time Rickwalt wants to change a variable, he has to go through that process. PLAN WITH LAST YEAR’S TAX FORMS
Essentially, tax-preparation software presents the same convoluted process if it doesn’t include a tax-planning component. For example, I do my taxes in Microsoft Works, using a set of spreadsheet tax templates sold by Heizer Software. But when I try to get a rough estimate of how different actions-an investment in a Keogh, or the purchase of a laser printer, for example-would affect my tax bill for the coming year, the procedure becomes a little awkward. I must switch from one tax form to another, go through all the calculations for each alternative, and save each version of the tax forms to compare against one another.
However, more and more tax-preparation packages include some sort of tax-planning feature. For instance, Swiftax gives you a “What If?” worksheet that lets you examine up to three alternatives to the figures already entered in your Form 1040. TurboTax and Tax Cut, two other tax-preparation programs, also include modules for tax planning. Such programs make it convenient to plan your tax situation, since you’ve already entered your current tax data. SPECIAL SOFTWARE TO PLAN TAXES
An especially easy approach to what-if tax planning can be to use software specifically formulated for it, such as Personal Tax Analyst. Most programs that help you plan taxes let you compare scenarios across the screen. It takes about a half-hour to key your current tax picture into Personal Tax Analyst, for example. The program then projects your taxes for five years. You can create up to five alternatives by selecting a carry-over option that will duplicate your current situation. Then, by changing as many or as few variables as you wish in each alternative, you can compare five years of tax bills for the five different scenarios.
Dan Caine, the tax attorney who wrote Tax Cut, explains that his program lets you enter estimates for any of 20 different tax variables. There are four on-screen columns: The first is actual taxes as you’ve entered them, and the other three are different scenarios. So after you’ve estimated your taxes for the year, you can create a few other possibilities. “What if I make only $28,000 instead of $35,000 this year? What if I spend $2,000 on a computer that I can deduct from my business? What if I start a retirement account instead and deduct the $2,000 from my personal income instead of from my business income?” These are the types of questions that Tax Cut will allow you to answer simply, without switching screens or spreadsheets. THE SPREADSHEET SOLUTION
If you know a little bit about how your taxes go together, you may not have to buy specialized software-you can create your own spreadsheets for tax planning. Just set up a spreadsheet that adds your income, subtracts your expenses, and gives you an estimate of your earnings for the year. The more details you add-including auto mileage at 26 cents a mile for 1990 or entertainment expenses at 80 percent deductibility-the more accurate your final results will be. Once a spreadsheet like this is set up, it’s not hard to keep up.
Learn the tax rates and multiply your earnings estimate by the right rate for a quick cut at your taxes. As this article goes to press, Congress is battling about what 1991 rates will be; for most people they won’t look radically different from the 1990 rates. For single taxpayers, adjusted gross income up to $18,550 is taxed at 15 percent; above that and up to $49,200, the tax rate is 28 percent; above that the rate jumps to 31 percent.
The cutoffs for married taxpayers filing a joint return are $30,950 (28 percent) and $82,050 (31 percent). THE COMPUTER, THE KEOGH, THE PARTY, OR THE COUCH?
Here’s an example of how you can use your own spreadsheet to plan your tax liabilities.
Let’s say your business is the happy recipient of an unexpected $2,000 in income that you’re not sure what to do with. You could buy a new computer or you could put the $2,000 in your Keogh plan. What if you splurged on a cocktail party for your employees, clients, and suppliers? It’d be good for business. On the other hand, the $2,000 is found money. Why not just take it out of the business and treat yourself to the now sofa you’ve been dying to get?
Each of these purchases varies your tax consequences, so the final cost of each will be different. The couch, of course, is clearly a nondeductible personal purchase. The Keogh is fully deductible, but from your personal taxes, not your business taxes. The computer and the party both are business deductions, but only 80 percent of the party is deductible, because it is an entertainment expense.
Here’s how to use a spreadsheet to figure out the after-tax costs of these different alternatives (see figure). This exercise will not include various state or local taxes, just federal taxes.
Set up column A for your expenses and column B to multiply expenses by your expected tax rate. Say 0.28 if you are in the 28 percent marginal tax bracket. That second column will tell you how much your personal deductions, including the Keogh, would save you on taxes.
Next, you want to compare business and personal deductions. Set up column C to multiply the expense by 0.433 (that figure combines the 28 percent rate with the 15.3 percent self-employment tax).
Finally, set up column E to consider the entertainment expense. That would take the initial $2,000 expense, multiply it by 0.80, and then multiply the product by 0.433, the combined tax rate.
It’s all very simple, and the worksheet offers a rough estimate of what the tax savings would be for the four alternatives-but the worksheet isn’t yet completely correct. Because half of the 15.3 percent self-employment tax is deductible on the 1040 form, you have to figure out how much of the payment that you are saving from your business Schedule C will be reclaimed in your personal taxes.
Do it like this:
After you’ve set up columns A, B, C, and E as detailed above, set up columns D and F so that they multiply the business purchase (or reduced entertainment expense) by 7.65 percent, or 0.0765. That figure is half of the self-employment-tax savings you would get by taking the proposed deduction. Multiply that number by 0.28, and it will show how much extra tax you’ll have to pay on the 1040 form because your self-employment-tax deduction is reduced. Subtract that figure from the savings estimate and you’ll have an accurate portrayal of how much the expense will save you in taxes.
In the example shown, let’s say you are in the 28 percent bracket and you are considering a $2,000 computer that will be fully deductible in your business. Multiply $2,000 by 0.28 to get $560. Alternatively, multiply $2,000 by 0.0765 and then multiply that result by 0.28 for the personal deduction you won’t get on your personal income tax.
Subtract that product-$42.84-from the $866 savings for a net savings of $823.16 (cell D9). That’s the amount you’ll save by using the $2,000 to purchase a computer instead of the Keogh, which saves only $560 on taxes outside your business. YOUR BOTTOM LINE
Now, we all know that there are reasons besides taxes to make buying decisions. Perhaps your in-laws are sick of sitting on the floor and you really do need a couch. But going through a calculation like this will give you a clearer idea of the costs of your actions. Consider this closing thought.
Buy the computer. Take the $823.16 in tax savings (cell D9) and put it in your Keogh (cell A10), for a further tax savings of $230.48 (cell B10). Spend that sum (cell A11) by taking your best clients and employees out to dinner, a business-entertainment expense that will ultimately net you a third deduction of $75.89 (cell F11).
Well, you can’t buy a sofa for that sum, but maybe a few nice cushions . . . of some tax-planning software, which is, of course, a legitimate business deduction.
If:X Personal Tax Analyst v1.0 ($79). Softview,
Managing Your Money v7.0 ($220). MECA
Software, (203) 226-2400.
Microsoft Works/Excel Tax Templates v1.0
($35). Heizer Software, (415) 943-7667.
Swiftax v1.0 ($80). Timeworks, Inc., (708)
Tax Cut v1.0 ($90). MECA Software, (203)
TurboTax v8.0B ($80). ChipSoft, (619) 453
LINDA STERN is a contributing editor for HOMEOFFICE COMPUTING.
COPYRIGHT 1991 Freedom Technology Media Group
COPYRIGHT 2004 Gale Group