In 2020, the number of persons who prepared and e-filed their own tax returns.
The use of software to prepare and submit your own taxes is an increasing trend. More than 72 million taxpayers prepared and e-filed their own taxes in 2020, a 25% increase over the previous year.
Should you get on the “do your own taxes” bandwagon if you haven’t already? Kathleen DeLaney Thomas, a noted tax law expert and law professor at the University of North Carolina in Chapel Hill, consented to an exclusive interview to help address these and other issues about tax software. The transcript of our chat follows.
“Many taxpayers like the ‘interview’ aspect of tax software.”
Defining Tax Software
What is tax software, and what can individuals really expect it to do?
Tax software, in my opinion, is anything that automates the tax preparation process. Instead of having to manually fill out paper forms and tally things up, the tax software handles it for us.
It may also assist us in staying organized. For example, if my tax software automatically imports my W-2 or 1099, I won’t have to maintain care of paper copies or spend time entering the figures. (Of course, we should double-check that the imported numbers match the ones on paper.) In these ways, tax software may save us a lot of time.
Many taxpayers may find the “interview” aspect of tax software useful as well. Tax software may assist taxpayers in determining which elements of the return are important to their tax position by asking a series of interview-style questions.
“Tax software cannot and should not be used in lieu of professional tax counsel.”
Investopedia: Conversely, what can people not anticipate from tax software?
Thomas: When I don’t know how the law applies to me, tax software cannot and should not replace tax guidance. If I know I can deduct charitable donations, the tax software does an excellent job of enabling me to simply input those values into the computer and report them in the appropriate spot on my tax return. It will also “perform the arithmetic” for me and inform me if my personal deductions are high enough to itemize or if I should take the standard deduction.
However, tax software cannot always inform me if a donation I made is tax-deductible. This is a legal issue. Similarly, suppose I pay for a client lunch and am unsure if it is a deductible business cost or a personal (non-deductible) consumption item. The tax software cannot decide how to correctly categorize the spending for me (deductible versus nondeductible).
Often, software businesses will offer law summaries to assist taxpayers in answering legal problems on their own. However, the IRS also publishes summaries of the law, so using tax software to obtain such written summaries is unnecessary.
Investopedia: Who benefits the most from self-preparation software?
Thomas: Self-preparation using tax preparation software makes a lot of sense for many filers with relatively uncomplicated tax circumstances. This is especially true for employees (as opposed to self-employed people/independent contractors) who do not have many itemized deductions. Self-preparation is straightforward if my major or exclusive source of income is earnings and I claim few additional deductions other than the standard deduction.
Even for individuals with more sophisticated tax circumstances (for example, those with a large number of itemized deductions or self-employment income), tax software may be useful if they are ready to invest additional time and feel secure filing their own return.
Self-preparation using software is a pretty simple procedure as long as no difficult legal problems are involved.
Investopedia: Is there a learning curve involved in using tax software for the typical person?
Thomas: Many initiatives, I believe, are designed to appeal to those who are unfamiliar with the tax system. If one’s tax position is straightforward, I don’t believe there is a severe learning curve.
“The greatest possible risk [of tax software] in my opinion is paying too much for unnecessary functionality.”
Investopedia: Are there any drawbacks to utilizing tax software?
Thomas: The largest possible hazard, in my opinion, is paying too much for unnecessary things. Updates and other services such as audit protection are advertised by software providers, and I’m not sure the ordinary tax software user understands if such upgrades and other services are beneficial or essential for their unique tax situation.
For example, if you are a wage employee (with no other source of income) and take the standard deduction, your chances of getting audited by the IRS are quite low (likely less than 1 percent).Purchasing audit protection is probably not a suitable investment for you.
I’m especially concerned about tax software businesses offering to “maximize” taxpayers’ deductions. Following the passage of tax reform legislation by Congress in 2017, the standard deduction is now extraordinarily large [over $12,500 for single taxpayers and over $25,000 for joint returns as of 2021]. As a consequence, only a tiny percentage of taxpayers (about 10%) itemize their deductions.
Unless they operate a company, the majority of taxpayers who take the standard deduction are unlikely to have any unique deductions that tax software might help them maximize.
Investopedia: Are any add-on services actually useful?
Thomas: I’m not sure whether any of the extra services are worthwhile. However, for more difficult tax returns, software solutions sometimes demand more rates.
For example, if you have to produce a Schedule C because you are self-employed, you will almost certainly have to pay a charge that an employee with a W-2 does not have to pay.
“The majority of taxpayers are considering self-preparation using software vs paying a tax return preparer, preferably a registered CPA.”
How can one choose between DIY tax software, a human tax preparer, and a tax attorney, according to Investopedia?
Thomas: A tax attorney is almost definitely not required to complete a tax return. Individuals seldom need the services of a tax attorney unless they are already embroiled in a legal issue with the IRS. High-income taxpayers may also retain lawyers to assist them in managing their affairs in a tax-efficient manner.
However, the majority of taxpayers are considering either self-preparation using software or engaging a tax return preparer, preferably a registered CPA. The decision to self-prepare or engage a professional is driven in part by the complexity of your tax position and in part by personal choice.
Even if they have basic tax issues, some individuals may feel more comfortable employing a professional and knowing there will be no errors or avoiding the headache of self-preparation. Others may choose to hire a professional because they have difficult tax problems that are best handled by a specialist.
Someone who operates a company or owns investment properties, for example, may benefit from hiring a professional to assist them manage and record income, self-employment tax, and deductions. Self-preparation software is likely to be less expensive, but preparing a sophisticated tax return yourself will be more time demanding.
Returning to the very easy tax situation: wage earner, few or no itemized deductions—these persons would almost certainly save money through self-preparation.
“Receiving a stimulus payment will need an additional step on this year’s (2020) tax return, but it should not be excessively onerous and is unlikely to necessitate the aid of a preparer.”
Investopedia: One additional twist for the 2020 tax year is the receipt of stimulus money in 2020. What should taxpayers be aware of when it comes to reporting this income and how tax software will handle it?
Thomas: Receiving a stimulus payment will need an additional step on this year’s  tax return, but it shouldn’t be excessively hard and shouldn’t necessitate the services of a preparer. The stimulus payment is not taxable and does not affect an individual’s tax burden in any way. However, if a person did not get a stimulus payment in 2020 but was qualified, or received less than they were eligible for, they may claim the difference as a credit on their 2020 tax return.
I’m not sure how software will handle this, but it should be as simple as reporting how much (if any) total stimulus monies were received in 2020.
“Filers earning less than a specific income level [$73,000 in 2021 adjusted gross income] should visit the IRS Free File website to learn about free filing choices.”
Are there any free options for some tax payers, according to Investopedia?
Thomas: Yes, again, and yes again. Filers earning less than a specified income level [$73,000 in 2021 adjusted gross income] should visit the IRS Free File website to identify free filing choices.
It is critical that people obtain software through our site rather than the software company’s website. If they do the latter, they may be charged unexpectedly for a service they believed was free.
Investopedia: What should consumers check for when purchasing for tax software?
Thomas: Compare prices. Look for a Free File option (through the IRS website) that works for you initially.
Is it protected by suitable security procedures, such as two-step verification, to prevent your information from being stolen?
Ease of use: is it well designed and user-friendly?
Are there easy-to-reach customer support services?
Is your tax return information securely stored for use the following year?
Can you log in and obtain a previous year’s return if necessary?
Will it import data from your previous year’s return into this year’s return?
“In terms of substance, tax software businesses are not severely controlled.”
Is there a tax software regulating body, according to Investopedia?
Thomas: Treasury and the IRS impose limited regulations on software businesses, requiring them to e-file returns and not leak sensitive information. They are likewise subject to FTC privacy guidelines.
The IRS has a contractual agreement with the largest software vendors (that provides some consumer protections).I’ve spoken about it a lot on Twitter.
Tax software businesses, however, are not substantially controlled in terms of content, as I explain in Regulating Tax Return Preparation.
I am not aware of any special consumer protection laws that protect customers from being oversold tax software packages. However, I am not an expert on non-tax rules, so I may be overlooking anything about consumer protection.
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