Tax planning 101…

OK, so our 2007 taxes are done. Up till now, taxes were always something I did after the end of the tax year. At that point, all the forms are available from the relevant taxing authorities; tax software is available; I know exactly how much we made, how much we paid in taxes; etc. So with all the ducks in a row, I would typically knock off a given year’s taxes by the end of January of the following year. Now, I’ve decided to take this a step further, and turn taxes into a kind of ongoing thing that I work on over the course of the tax year. Being the obsessive financial control freak I am, this is always something I have wanted to do, but it’s always seemed prohibitive. Estimating the current year’s income is not a big deal and can be done with varying degrees of accuracy, depending on how much time you want to spend. But what about tax forms, software, etc.? These are typically not available until late in the tax year. So how do we do this? Enter the spreadsheet.

I’ve always used tax software to prepare our taxes. Tax software is great for what it does: it streamlines the tax preparation process, generates IRS-friendly hardcopy, and facilitates e-filing. Where it falls short, IMO, is in its ability to play out “what-if” type scenarios. What happens if I use FIFO vs. average cost in computing a capital gain? What would happen if I take the standard deduction vs. itemizing? How close am I to getting tripped by the AMT? etc. I want to be able to tweak certain numbers on my forms, and instantly see the end result in taxes owed, refund, etc. With tax software, I have always found it cumbersome to go through, tweak things like this, and see the results. This is the kind of thing a spreadsheet excels at (no pun intended). So, for 2007, I took the plunge and wrote up a spreadsheet to do my initial tax calculations, falling back on the tax software to verify that my numbers are correct. It wasn’t too hard, and I really like the instant gratification I get from changing one number and immediately seeing the result. I also realized something else, after using software exclusively for so many years: doing the spreadsheet really gave me a better feel for how the tax code works, and why certain things are the way they are. Software, by its design, insulates the user from a lot of what is happening behind the scenes. This is good in some ways but bad in others.

After the initial spreadsheet exercise, I realized that the spreadsheets would also be useful for tax planning during the current year. The key to this is keeping up with changes to the tax laws since the previous year, and adjusting the spreadsheet to accommodate them. Most years, there aren’t many changes. The IRS re-indexes the tax brackets every year for inflation, which changes the tax tables as well as employer withholding tables. Using this data, one can compute paycheck withholding and come up with a pretty clear picture of salary income for the coming year. Projecting the other stuff (investment income, etc) involves a bit of hand-waving, adjusting various things to account for inflation, etc. The important thing to keep in mind is that most peoples’ tax situation does not change much from year to year. As the year progresses, I’ll just keep updating the spreadsheet to replace projected numbers with real numbers.

Doing this opens up a lot of planning possibilities. I now have a much clearer picture of how many withholding exemptions to claim on my W-4, and as the numbers become more accurate over the course of the year, I’ll be able to do more accurate year-end planning too. And, my taxes will be more-or-less finished at the end of the year.

This exercise has already helped me out this year. It alerted me that I’m losing a capital-loss write-off that I’ve been able to claim for the last few years (since selling off some of my wife’s really bad mutual funds :-)). Well, after several years of carryover, I’ve finally churned through the loss, and will flip back into the black in 2008, losing the write-off and creating an extra several hundred dollars in tax liability. So, time to bump down the withholding exemptions and tighten the belt a bit. Better to know that now, then get surprised with a huge tax bill (complete with penalties etc) next year.

1 thought on “Tax planning 101…

  1. I found your site on technorati and read a few of your other posts. Keep up the good work. I just added your RSS feed to my Google News Reader. Looking forward to reading more from you.

    Mike Harmon

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