Automated Finances: Proceed With Caution

Technology has made it possible to automate many financial tasks, and most personal finance experts will suggest that you automate as much of your finances as possible to take you out of the process. You set it and forget it with forget it being the key phrase.

By taking you out of the process, negative factors such as ego, procrastination, disorganization, and emotion cannot sabotage progress toward your financial goals. Automation replaces self-discipline.

While automating some tasks such as contributions to retirement and saving accounts makes sense, automation is not a silver bullet for those who are unorganized or who lack self-discipline. Effective management of personal finances still requires the conscious attention of the one who is responsible.

Automated contributions to retirement and other saving accounts

Where automation shines is in the area of saving. Automating contributions for retirement saving and other saving accounts works because the decisions whether to save and how much to save are only made once. In addition, with automated contributions to saving accounts, the saver never has an opportunity to spend the money because it is deposited into saving accounts before the saver even knows it exists: out of sight, out of mind. Automation makes saving painless.

However, do not set it and forget it. Automated contributions to saving accounts should be reviewed and updated once a year with an eye toward increasing the rate of saving by a percentage point or two each year.

Automated bill payment

Having all your bills paid automatically is convenient but also a bad idea. Bills for products and/or services whose monthly balances fluctuate with usage such as utility bills and credit card statements should not be automated. You need to review those bills and statements for accuracy and to keep abreast of usage trends.

It is much easier to dispute a charge or amount of usage before the bill is paid rather than after. When you dispute a bill before you pay it, you hold all of the cards. The organization that issues the bill will give your dispute immediate attention because they want to get paid. With automated payment, there is little chance that you will catch an error or question a charge, and if you do, the bill will have already been paid. With payment in hand, there will be little incentive for the billing organization to take your complaint seriously.

Reviewing utility bills and credit card statements prior to payment is a good way to discover opportunities for cost cutting. Automated bill payment gives you no reason to even look at the bill or statement; they have already been paid. You lose out on potentially valuable information about your finances.

Think twice before you automate the payment of semi-annual and annual bills such as premiums for homeowner’s insurance, premiums for automobile insurance, subscriptions for software licenses or services, memberships, and so forth. Automatic payment or renewal opens you up to price increases that may go unnoticed. You will be less inclined to consider shopping for a better deal or to evaluate the continued use of a software or service when renewal is automatic because you have been taken out of the process. You probably won’t even notice a price increase.

Monthly billing for products or services with a set amount such as car payments, mortgage payments, and other loan payments, rent, life insurance premiums, services such as Netflix, internet ISP fees (provided you are not subject to data usage charges), cell phone fees (provided you are not subject to data usage charges), and so forth do make good candidates for automated payment. Many of these bills have to be paid, so it is best to make payment automatic. If you decide to cancel a service, you only risk one monthly payment.

Forced automatic renewal for annual fees

What about software licenses or services that require automatic renewal for yearly fees or annual membership? Forcing customers to accept automatic renewal indicates to me that the company behind the software or service is not confident in the value of its product offering. Most of these businesses offer steep discounts to entice new users to enroll. From my experience, the discounted price is what the software or service is actually worth. Annual renewals are charged at the full price, and most often, with no advance notice and no opportunity to cancel and receive a refund. This is where the automatic renewal comes into play. These companies hope you will forget about the automatic renewal so they can overcharge you for the next year’s subscription or membership.

The best thing to do to avoid being surprised by automatic renewal is to mark a date on your calendar that is a couple of months before your subscription or membership renews, then cancel your subscription or membership at that time. Do not worry; the balance of your subscription or membership will still be in effect until it expires, but you will be off the automatic renewal hook. Don’t wait until the last minute to cancel. If there is a glitch in the cancellation process (website is down, error message), you may not have time to correct it before your account automatically renews. Also be aware that there may be a discount for automatic renewal and by canceling you may lose out on this discount if you decide to continue with the software or service for another year.

Remember that you are ultimately responsible for timely payment. If your automated bill paying service makes a mistake, you are on the hook. Do not assume your automated payments are processed correctly each month. Pay attention to confirmation emails and reports that document automated payment. You can set it but do not forget it.

K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages

Measure Your Financial Health With Power Percentage

Peter Dunn (www.petetheplanner.com), author and speaker on personal finance, has developed a helpful tool that he calls Power Percentage. It is designed to give the user an objective measure of financial health. The tool measures how much of a person’s gross monthly income is spent on consumption. Less money spent on consumption produces a higher Power Percentage result. Those with higher Power Percentages have healthier personal finances because they are living farther beneath their means.

Calculate your Power Percentage

Here is how to calculate your Power Percentage. Total all of your monthly saving activity such as:

  • Contributions to retirement plans, including employer match, if any.
  • Contributions to a college fund.
  • Deposits into savings accounts that will not be spent in the immediate future.
  • Deposits into other investments.
  • Contributions to a qualified Health Savings Account that are not earmarked for a specific procedure in the immediate future.

Now add to your saving activity the total of your monthly debt repayment activity such as:

  • The principal amount only of your mortgage payment (exclude interest, property taxes, and insurance).
  • Payments on medical and student loan debt (principal and interest). Do not include interest-only payments.
  • Payments on credit card debt, but only on credit cards you are not currently using.
  • Monthly payments on any other debt except auto loans.

The final step is to divide the total of your monthly saving activity and debt repayment activity by your gross monthly income (the income figure before any deductions are made). Now you have your Power Percentage. As an example, say the total of your monthly saving and debt repayment activity is $2,000 and your gross monthly income is $6,000. Divide $2,000 by $6,000 to get your Power Percentage which is 33% ($2,000/$6,000 = 33%). In the example, two-thirds of the monthly income was spent on consumption while one-third was invested in saving or debt reduction. Note: The repayment of mortgage principal is both debt reduction and saving as the repaid principal becomes equity in the house.

What your Power Percentage means

Where do you rank on the Power Percentage scale?

  • Less than 10%: Poor. Nearly all of your income is spent on consumption
  • 11% to 20%: Fair. You are dedicating some income to saving and debt repayment but not enough.
  • 21% to 34%: Good. This is a healthy mix of saving, debt reduction, and consumption.
  • 35% and over: Excellent. You are on your way to financial independence.
  • Rating the Power Percentage tool

    The Power Percentage gives a snapshot of your finances that provides a useful measure of the constructive use of monthly income to improve your finances. The idea is to increase the Power Percentage by lowering the amount of gross monthly income that is spent on consumption.

    The Power Percentage tool does not distinguish between saving and debt repayment, treating both equally. As a result, it may give a somewhat misleading indication of financial health. Using our example above, a person with a gross monthly income of $6,000 who is on an aggressive debt retirement program might pay off $2,000 of credit card and other debt each month and contribute nothing at all to savings and register a 33% Power Percentage while another person with no debt contributes $2,000 of her $6,000 monthly income to savings and has the same 33% Power Percentage. But the financial health of these two people is not the same. The person with no debt who saves $2,000 per month is in a much better financial position than the one who is paying off $2,000 worth of debt each month with no money going into savings.

    In addition, the Power Percentage is no indication of a person’s financial liquidity or net worth, two critical factors in determining financial health.

    Spending less and saving the rest is a core principle of a cash-based lifestyle and a frequent topic on this blog. It is the key to improving your personal financial health and security. The Power Percentage can help you evaluate and track your progress in this area.

    K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages

IRS Audit Red Flags – Part 2: Business

Just being self-employed or the owner of a small business makes you more likely to be audited, but the following are additional Internal Revenue Service (IRS) audit red flags for small business/self-employed tax returns.

1. Home office deductions. This deduction is frequently abused: either the office in the home does not qualify as a home office under IRS rules or the expenses deducted for a legitimate home office are inflated. Taking this deduction is a huge red flag. Make sure you understand the rules that apply to the deduction and keep accurate records of expenses if you plan to take this deduction. Also, expect an audit.

2. Filing a Schedule C. The Schedule C is for computing the profit or loss from a sole proprietorship. Most home-based businesses operate as sole proprietors. The IRS knows from experience these businesses often do not keep accurate records of income and expenses and business and personal funds are often co-mingled, resulting in a less than accurate computation of income. The IRS suggests forming a separate business entity such as an LLC, S-Corp, or Corporation to conduct business to avoid this red flag. However, these separate business entities are much more complex in structure, accounting, and taxation than sole proprietorships. They are expensive to create and maintain and are not practical for very small businesses. Detailed record keeping, an understanding of basic accounting, and a separate business checking account will provide accurate information with which to complete the Schedule C and withstand an audit.

3. Entertainment deductions. This is another habitually abused deduction and the IRS knows it. Business entertainment deductions that are out of proportion to the size of the business will get flagged for an audit. Know the IRS rules for defining business entertainment, abide by them, document thoroughly, and keep accurate records if you take this deduction.

4. Losses reported from hobby instead of business venture. Many people turn hobbies into businesses. When does a hobby become a business? When it makes a profit. The tax code does not allow for the deduction of hobby expenses. If you report a loss for your business, this is a red flag for an audit. The IRS will want to determine if yours is a hobby or legitimate business.

5. Low income with large deductions. If your business return shows a low sales figure but your expenses are proportionately high, your return is likely to get flagged for an audit. There can be a number of legitimate reasons for a business to have low sales and high expenses: if it is a new business, if there was the loss of a large customer or contract, or if market conditions stifled sales. Of course, the IRS assumes the proportionately large expense figure contains illegitimate expenses, and they will want to verify the legitimacy of those expenses in an audit.

6. Claiming a loss on a business. If your business return shows a loss, it will be flagged for audit because a loss means no income to be taxed and no revenue for the government. There maybe legitimate reasons for a loss as noted in number five above, but the IRS will assume the books have been cooked. A loss can be created by underreporting sales or inflating expenses or both. The IRS will audit for legitimate expenses and possibly sales reporting.

A common thread running through these business return red flags is the reliance on proportion and common sense by the IRS. The IRS knows the standard profit margins and corresponding operating expense ratios for various classes of businesses. If your profit margins or expense ratios significantly vary from the standard, the IRS computers will flag your return for audit. Most small businesses make a profit after the first year or two; if your business is established and shows a loss, it makes the IRS suspicious and your return may be flagged for an audit.

I have filed a Schedule C for the last twenty-three years and have not been audited. Some years, I claimed entertainment and travel expenses and was not audited because those expense totals were reasonable given the type of business and the volume of sales. I have never taken a home office deduction because my home office would not qualify under IRS regulations. I have had several businesses over the years and all of them had expenses that were out of proportion to sales the first year or two due to start-up costs and the time it took to develop the business. None of those returns were audited. I keep detailed and accurate records and balance my business checking account against my business ledger each month. Every transaction is documented and accounted for. I am prepared should I ever get audited.

A red flag does not guarantee an audit and the odds are against the average individual or business being audited. Nevertheless, you may be audited, so practice due diligence in your personal and business affairs; document and keep good records; read and understand IRS regulations regarding the reporting of income, deductions, expenses, and any credits that pertain to you; get professional tax advice and preparation if necessary.

K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages