Test drive highlights tax software limits

Like Watson, the IBM computer that stumped the champions on Jeopardy, tax-preparation software uses sophisticated technology to perform a task previously done by a human — in this case, your neighborhood tax preparer.

For taxpayers with straightforward returns, tax software gets the job done, at a fraction of the cost of a tax preparer. If you file a 1040-EZ, there's simply no reason to pay someone to do your taxes for you when you can do it online for less than $20 (or free if you qualify for the IRS Free File). Most tax software programs are also adept at handling returns that claim common tax breaks, such as the deduction for mortgage interest and charitable contributions.

But this year's tax software review also revealed the limitations of these programs. Taxes have grown so complex that even those of us who don't invest in individual stocks, own rental property or run a small business could find ourselves in need of advice from a flesh-and-blood tax preparer. Here's where we ran into trouble in our annual test drive:

Retirement savings

Most taxpayers with lengthy investment portfolios hire a professional to prepare their returns, with good reason. Even Watson would have a hard time figuring out the cost basis for a stock you bought in the 1980s and sold last year.

But these days, something as common as saving for retirement can create tax headaches, especially for taxpayers who converted a traditional individual retirement account to a Roth IRA.

A law that took effect last year lifted income restrictions on such conversions, allowing thousands of taxpayers to convert for the first time. In addition, the law gave taxpayers who converted in 2010 the option of splitting the income tax from the conversion between 2011 and 2012. For example, if you converted an IRA valued at $100,000 last year, you could opt to pay taxes on $50,000 of the income in 2011 and $50,000 in 2012.

For most of us, that's the obvious choice. Why pay taxes now when you can pay them later? But if you expect your income to increase in 2011 and 2012, you may want to take the tax hit now.

If you make that determination, be prepared to wrestle your tax software to the ground. TurboTax provided the easiest workaround: While it advises users that deferral is the preferred option for most taxpayers, it offered a way to pay your taxes in 2010. Still, a worksheet would have been nice. Instead, we had to use a back-of-the-envelope calculation to figure out how much it would cost to pay the tax bill in 2010.

H&R Block At Home Deluxe deferred the income, with no explanation of what it was doing, or why. To learn more, you have to advance to the "Adjustments and Deductions" section and check a box for IRA conversions and rollovers. This section provides a useful description of the pros and cons of paying taxes now vs. later, but it's so far away from the initial entry that it's easy to overlook.

CompleteTax offers a box you can check if you want to have your conversion taxed in 2010. However, the language was confusing, and when we posed a question to the help section about our options, we were told we would need to upgrade to get an answer.

The most troubling treatment of an IRA conversion occurred in our test drive of TaxAct. After we entered information about our conversion, the program treated the entire amount as taxable in 2010. This created such a large tax bill that we experienced heart palpitations and had to walk away from the computer. A TaxAct spokesman said this resulted from a data entry error on our part, but it was an easy — and expensive — mistake to make.

The bottom line: If you converted a large IRA to a Roth last year, it may be worthwhile to consult with an experienced tax preparer.

Miscellaneous income

If you're self-employed or starting a business, you're probably better off paying a tax preparer to do your return. Otherwise, you risk overlooking valuable deductions, or making errors that could attract scrutiny from the IRS.

But many people who work for an employer also earn a little extra income through consulting, freelancing or tutoring kids at the local elementary school. This income typically appears on Form 1099-MISC.

TurboTax did the best job of handling this income, although it strongly suggested we upgrade to its Home & Business version (which costs about $75). Entering miscellaneous income was more laborious with H&R Block At Home.

The bottom line: You shouldn't have to upgrade to a premium software program to report a couple of hundred bucks you earned mowing lawns last year. But you may need to root around a bit to find the right place to enter this information.

Other thoughts:

•As has been the case in past years, TurboTax provided the clearest instructions of all the programs we tested. However, if you're a longtime desktop user, you may want to consider making the leap to the online version. It's cheaper and updates automatically. In our test drive of the desktop version, we had to endure several updates, one of which lasted more than 10 minutes.

•H&R Block At Home did a workmanlike job on our tax return — and costs about 25% less than TurboTax. Block has enhanced its data-import function, which lets you electronically transfer information from your W-2, mortgage statements and other documents, but it still lags behind TurboTax in this regard.

•TaxAct continues to be the preferred choice for cost-conscious taxpayers. Its standard program is free. However, if you want any guidance, you'll need to upgrade. For that reason, it's best-suited for people with a good grasp of tax laws or those with simple returns.