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

IRS Audit Red Flags – Part 1: Individual

It is time to prepare your 2016 income tax return, account for your income, and pay up. It would be nice if it were that simple, but it isn’t. Filing your return and paying the amount of tax due may not be the end of it. To keep taxpayers honest, the Internal Revenue Service (IRS) pulls a small percentage (less than 1%) of returns for audit.

Even if you are completely honest and forthcoming about income and deductions when you file your tax return, you do not want to be audited if you can help it; audits take your time, can cost you money if you need to hire representation, and are stressful.

According to the Internal Revenue Service, returns are not selected for audit at random; something about the return triggers an audit. Try to avoid the following audit red flags when filing your return.

Rounded numbers: When the numbers you enter end in zeros, the IRS suspects you are not using actual figures. Occasionally, you make have an actual number that ends in zeros. One such number will not likely flag your return, but a lot of rounded numbers will.

Unreported income: Any income you fail to report that has been reported to the Internal Revenue Service by a third party (1099 and W-2 income) automatically flags your return.

Sloppy or incomplete information: A tax return with math errors or that is incomplete will trigger a red flag. The IRS advises the use of tax preparation software to avoid this red flag.

Charitable donations: This deduction is often abused, so if you claim charitable donations in excess of the average for your income bracket, your return will be flagged.

Earnings of $100,000 or more: People with high incomes make it easy for the Internal Revenue Service to justify the expense of an audit. Consequently, those with incomes over $100,000 are 500 times more likely to be audited than those who earn less than that amount. You cannot avoid this red flag if you make over $100,000, so be sure to obtain and retain good documentation for any deductions or credits you claim.

Low income for your profession: The IRS has data on the average income in your locale for people in your particular profession. If you report income significantly lower than what the IRS would expect for someone in your profession, your return may be flagged to verify income.

Differences in Federal and State tax returns: When information on your Federal income tax return does not match the information you report on your State income tax return, red flags are triggered at both the Internal Revenue Service and your state revenue department. The IRS recommends using tax preparation software for your Federal and State returns to avoid this red flag.

Large swings in income: The Internal Revenue Service likes consistency. Consequently, large swings in income that cannot be explained by W-2 or 1099 reporting will cause your tax return to be flagged.

  • Job expenses: If you are a W-2 employee and take a job expense deduction, your return will be flagged. The IRS knows from experience that many more people take this deduction than can legitimately do so. They will assume that you may be one of those people.
  • Tax avoidance transactions: If the Internal Revenue Service discovers you have participated in tax avoidance transactions or if they suspect that you have, your return will be flagged for an audit.

    There is no way to absolutely avoid an audit of your federal income tax return. Nevertheless, the odds are in your favor that you will not be audited. You can improve those odds by avoiding audit red flags where you can and using tax preparation software to complete your return.

    Part 2 of IRS Audit Red Flags will address business returns.

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