Garbage In, Garbage Out: The Problem With Tax Preparation Software

February 18, 2015

A couple of weeks ago, I received a desperate email from Alex who was using tax preparation software to help him prepare his tax return. It seems he thought he could avoid taxation on his 401(k) from his prior employer by rolling it directly into a Roth IRA.  While it’s true he could directly roll funds from his 401(k) to a Roth IRA, it is NOT true that this will avoid taxation. Only after-tax money may be deposited into a Roth IRA, therefore the amount rolled over—a sum of nearly $20,000—would be treated as taxable income for the year.

When Alex tried completing his tax return the first time, the software told him that he owed the IRS an additional $5,000! Fortunately, his credit union was wise enough to suggest he re-characterize the account as a traditional IRA, which alleviated the tax problem, but then Alex thought he had a different problem. When he tried to complete his return the second time, the software was warning him that he had over-contributed to the traditional IRA, and that if he didn’t remove the excess contribution—roughly $13,500—he would have to pay a 6% penalty on the excess contribution every year until the excess contribution was removed.

Alex was in a pickle. On the one hand, he didn’t want to face a 6% penalty every year on the excess contribution but on the other hand, he didn’t want to pay a 10% penalty on an early withdrawal (since he was under age 59½).  That’s when I got his email.

The good news is that Alex DID NOT make an excess contribution to his traditional IRA.  In fact, he didn’t make a contribution at all. What he did was roll over funds from a qualified plan. What had happened is when the tax preparation software asked Alex if he had contributed to a traditional IRA, he indicated that he had—in the amount of nearly $20,000.

Luckily, Alex’s employer offers access to financial planners that can assist when warnings pop up on tax preparation software. But what if Alex did not have access to a planner, or what if his rollover was less than the contribution amount? Alex could have filed an incorrect tax return, which at best would require him to file an amended return later or at worst, could result in him owing the IRS back taxes and penalties.

I’m a big fan of tax preparation software, and I think more taxpayers should use it and save the money they would otherwise spend on a professional tax preparer , but tax preparation software is not foolproof. As illustrated above, the tax return that comes out depends on the tax information that goes in, and if the wrong information goes in, well, you see what can happen. It’s like what my middle-school computer teacher often repeated: garbage in equals garbage out.