Look at the graph for the search term IRS in the United States:

The graph generally has two spikes yearly. Why might this be? I’ll take a guess.

The first spike is in Jan-Feb when people are probably double-checking definitions and new rules (what is a dependent, how much charity is deductible, etc)

The second spike is for April when people are likely scrambling to file near the deadline.

(And if you’re wondering, the lower, more regular graph, is about news references and shows fewer spikes.)

I’m working on tax stuff now…not quite last minute, but definitely contributing to the March traffic.

How’s your tax prep going?

But what does planning early mean? There was a time that I only had a vague idea. I went through the same unpleasantness each year. I would file away tax documents in a folder. I would schedule an appointment or get tax software. I would get psyched to do my taxes. And then I would hope I had everything I needed.

Not that I ran into trouble with missing documents at a tax preparer. Or that it mattered much when using tax software at home. But I often felt a process like taxes is about organization and in a sense being over-prepared.

What do you need to file taxes?

A while ago I learned of the idea of a “tax checklist.” A tax checklist is exactly what it sounds like. It is a checklist of all the tax documents you need to file.

Not only is the tax checklist a good way to double-check, but it is also a useful planning tool. I affix a tax checklist to the very folder where I store my tax documents. Now I can simply check off tax documents as I get them! Tax time really becomes a breeze.

A truly comprehensive tax checklist would cover every contingency, and it would be as dry and unreadable as the current tax code. So keep in mind the following list is just a starter. I trust you’ll consult an actual tax professional if in doubt.

Below is a tax checklist that contains many of the common documents. The list is based on other checklists from MSN Money, Yahoo Finance, Turbotax, and H&R Block.

For convenience, I’ve also created a printable file (and a spreadsheet) so you can affix the tax checklist to your tax folder.

And consider printing out a few more for family and friends–they’ll definitely be grateful for the tips!

Tax checklist

Printable pdf

Social security number for you / spouse / children

W-2

Interest income 1099-INT

Dividend income 1099-DIV

Broker transaction proceeds 1099-B

Retirement plan distributions 1099-R

Unemployment payments

Social security payments received

Other income

State and local tax refunds

Alimony

Gambling and lottery winnings

Mortgage loan interest

Charitable giving

Medical expenses

Student loan interest

IRA and retirement contributions

Job search expenses

Moving expenses

State and local taxes

Real estate taxes / Rent paid

Home equity loan or line of credit

Auto loans and leases

Tax preparation fees or software

What items would you add to the list? What tax prep organization tips do you have?

Rate of return (ROR, or more commonly called ROI)

ROI is the simplest return measure and also the most often quoted. ROI is defined as the percentage increase or decrease of an investment over a period of time. This method gives an idea of how much an investment is growing or declining.

Here’s an example. Imagine an investment started at $1,000 and grew to $1,100 by the end of the year. In this case, the ROI is equal to the percentage increase of 10 percent.

In general, you can calculate the ROI once you know:

1. The starting investment value (C₀)
2. The ending investment value (C₁)

The general formula is:

One thing you might notice is the ROI formula doesn’t include a time component. Mathematically, we would have gotten the same ROI had the investment taken place over 1 day, 1 month, 1 year, or even 10 years. This is why the ROI is usually stated with a time period, like “a 10 percent daily return” or “a 10 percent annual return.”

There are two reasons the ROI is useful.

First, ROI gives a quick assessment of investment performance, and it helps that ROI can be computed mentally.

Second, ROI is useful when comparing two investments over the same time period. If one mutual fund had an annual ROI of 15 percent compared to another that had 10 percent, you could conclude the first performed better.

Unfortunately, there are two fatal flaws with the simple rate of return method.

First, it does not allow you to compare investments over different time periods. Suppose you were trying to compare two investments, one that had a 5 percent return over 1 month versus another that had a 50 percent return over 1 year. Which is better? It is not easy to draw conclusions.

Second, what if you invested in several increments? Suppose you invested $100 monthly for one year and ended up at $1,300. What would you investment return have been over that time period?

These two issues are realistic concerns for the individual investor. And then there are other issues like taxes and dividends. How do you figure out investment performance then?

A more flexible framework is needed and this is where IRR comes in. While the IRR is mathematically more complicated, understanding it is vital for tracking investment return.

Internal rate of return (IRR, also called yield or APY)

I bet you are already familiar with IRR because it is given a special name when quoted on products like CDs or savings account. The IRR is called the APY, the annualized percentage yield.

IRR is a more sophisticated return measure and is widely used in the finance world for valuations. IRR is the annualized compound rate which can be earned on invested money, also known as the yield. IRR takes into account the investment growth but unlike ROI it also accounts for the timing of the cash flows.

Some examples are: a 5 percent monthly return is an IRR of about 80 percent. Making 12 monthly investments of $100 that accumulate to $1,300 is an IRR of about 15 percent.

How can you calculate those figures? In theory, one could go to the math formula and try to solve a complicated polynomial. The calculating complexity is probably one reason the IRR was not as widely quoted.

Nowadays, calculating the IRR has been made easy because of numerical methods. We can calculate IRR in spreadsheets fairly easily. The specific function is “XIRR” in Open Office Calc, Google Documents spreadsheet, and Microsoft Excel (*I think this requires the Analysis Toolpak add-in).

Calculating IRR is done by creating a time series of cash flows. One column is a listing of all the dates of cash flows-including investments, dividends, taxes, etc. The other column is the numerical values of those events. The IRR can then be calculated using the “XIRR” function in a spreadsheet with the appropriate ranges. Here are some examples of calculating IRR.

Example 1: converting monthly to annualized yield

Suppose you invested $1,000 on January 1, 2008 and got back $1,050 on February 1, 2008. What is the annualized yield of this investment (ignoring taxes, etc)?

Here is the IRR calculation:

Note that cash outflows (buying) are negative and cash inflows (selling) are positive.

Example 2: monthly investments

Suppose you invested $100 on the first of each month during 2007 and got back $1,300 at the end of the calendar year. What is the annualized yield of this investment (ignoring taxes, etc)?

Here is the IRR calculation:

Example 3: buying and selling

IRR is flexible enough to handle even harder problems. Take the example of buying and selling during the year.

Suppose you invested $100 on January 1, 2008, sold for $90 on June 1, 2008. You later bought back $100 on July 1, 2008 and then sold for $150 at the year end. What would the annualized investment return be here?

This situation can be solved using the IRR method:

Example 4: adding in taxes, dividends

The real beauty is IRR can measure performance with realistic factors like taxes and dividends. I’ve made up numbers in the next example of dividends and taxes. You can modify them for your actual performance.

Suppose you invested $100 on January 1, 2008, received a $3 dividend on June 1, 2008. You sold at the year end for $105 but had to pay taxes of $1 for the dividend and capital gains. What is your net annualized yield?

Here is the IRR calculation:

I hope these examples give you can idea of the flexibility of the IRR. It’s okay if you still have questions about how to calculate it. Just ask any of your competent friends with economics or accounting degrees and they should be able to run the numbers.

In summary, the IRR is harder to compute but it gives a more accurate picture. Plus, in some cases it is the only way to figure out the return. For my money, I focus on the IRR.

(optional) Math of IRR:

In general, you can calculate the ROI once you know:

1. The cash flows of the investment (C₀, C₁, …)
2. The time elapsed in years after the first cash flow (t₁, t₂ …) where (t₀=0)

The IRR is the value (or values) that solve the following equation:

The IRR cannot always be solved analytically so we rely on numerical methods, like financial calculators or spreadsheets.

Related articles on the web

Tracking your success–a nice article from fool.com on why IRR is the appropriate metric

How to calculate your return on investment–a step by step explanation from Fat Pitch Financial on how to get IRR…plus a free spreadsheet

Disclaimer: This explanation is for educational and recreational purposes only. Every attempt has been made to make the article accurate for the time of writing. Do your own research or consult a professional before making an investment decision.

This seemed curious to me, so I started a discussion and ran some numbers. Our conclusion: he could live on that money and save more. The problem was he was eating his retirement savings.

Why focus on food?

There are many things you can do to boost savings. You can earn more. You can cut back on social activities. (Incidentally, saving more is better than earning more for a specific goal).

I focus on food for one reason. It is about 15 percent of our spending, and a stunning one-third of that comes from expensive meals at restaurants (see: cool chart from the BLS).

Eating at home is within your control and can make a big impact. Plus, preparing food will likely help you improve your biggest asset (even bigger than your career). For the person at hand, a few small improvements boosted his possible savings by 20 percent.

I will stylize our discussion for this article. It dealt with a hypothetical single-filer living in Chicago. Let’s go to the numbers.

What you can’t control immediately: taxes, loans, housing

It’s instructive to estimate costs that cannot be immediately changed. We conservatively estimated living costs in Chicago for the single-filer and came up with these annual figures:

Granted these are very rough figures, but let’s take it as a starting point.

Note there is only $8,800 left to spend on personal expenses.

Personal expenses like food are in your control

The good part is food is a relatively controllable expense. You can eat out all the time, or you can go to clubs and get bottle service, or you can decide to live frugally.

Frugal living can make a huge impact in saving. Imagine one cooked at home for a few meals instead of eating out. We estimated the change would reduce the $500 monthly food expense to a $350 one (some people spend less and still eat well). This change aggregates to $1,800 a year.

This is a decent amount of money. In fact, that’s over 20 percent of the $8,800 that is available to save!

But what if you can’t cook?

It was at this point that I got into an argument that cooking at home is not realistic for young people. They don’t have time or don’t know how.

My response was simple: then learn and make it a priority. When you have limited resources, you have to take extra steps and accept your situation. You can’t change the tax code; you can’t change your debts; you can’t change the price of gasoline. But you can change your lifestyle, like what you eat.

(If you’re interesting in learning how to cook, here’s a decent cooking site that appeals to technical people.)

What’s are your tips about eating at home to save money?

Years later I would recognize the parents’ strategy as an important game theory concept. They were playing what is known as a grim trigger strategy, a strategy of eternal punishment resulting from a single provocation or “trigger.”

We all use or attempt to use grim trigger strategies on occasion. In general, a grim trigger strategy sounds like the following: “I’ll play nice with you as long as you do the same. But if you ever betray me—even once—then I’ll never forgive no matter how much you apologize.”

The strategy is usually discussed in classrooms in the context of the iterated Prisoner’s Dilemma. The example is interesting but it requires technical math like infinite sums and discount rates. By the time many of us get the math done, we’ve lost much of the intuition.

So instead I will keep things grounded by discussing an example from estate planning. Amazingly, the grim trigger strategy is an essential idea for why a certain kind of trust works.

One problem in estate planning

Imagine a parent wants to transfer wealth to his 18-year old child in a tax-effective manner. The simplest way to transfer money tax-free is by giving a gift. Under current IRS tax laws, the parent could give up to a certain amount ($12,000 in 2008) without incurring taxes.

But there is a potential problem with this transfer. The gift becomes the child’s money and can be spent however the child sees fit. Many parents rightfully fear young children would waste the money. The issue is not having complete control. For many, it would be sufficient to let the child grow up a bit, to say age 25 or 30, to be mature and have perspective. Unfortunately, adding such a condition would disqualify the gift from its tax exclusion. The IRS wants to make sure the gift is a real rather than a tax-sham and so it is specified the child needs to have “present interest” in the gift as opposed to “future interest.”

The present interest condition creates a situation that can unravel quickly. A parent might only want to give money to a child that would responsibly save it. But in a one-shot game, an irresponsible young child will always choose to spend the money. We end up in a situation where parents don’t give and children don’t get, far from the desired outcome of marking money for the future.

Is there any way to get to a better outcome? That’s the idea behind a trust the Crummey family created.

The Crummey trust

People have tried many schemes to earmark money for the future but still qualify for the gift-tax exemption. Eventually the Crummey family in the 1960s came up with a trust setup that was ruled to be legal and now bears their name.

Here is the history and the idea of the trust:

In the late 1960s, Mr. and Mrs. Crummey tried to get around the present interest gift tax limitations. They created a trust for the benefit of their children, but with a new idea. The trust provided that the beneficiaries would be given notice of any gift to the trust and the beneficiaries would then have a limited right to withdraw the gifted assets for a specific number of days. If the beneficiaries did not exercise their rights of withdrawal within the time allotted, … gifted assets would thereafter be locked in the trust. [to be sensibly distributed when the children are older]

Mr. and Mrs. Crummey took the position that these gifts were a “present interest” because each beneficiary had a present right to withdraw the funds for a limited period of time. The annual gift tax exclusions for the gifts to the trust would be available. No gift tax would be due. The IRS did not like this idea and challenged the Crummeys. Fortunately for us, the IRS lost hands down. [source, minor formatting mine]

The idea can be viewed as more than a tax scheme and as a reflection of equality. In some sense, a parent with a young child should not be at a disadvantage in estate planning compared to a parent with an older, responsible one. The Crummey trust makes this possible.

The grim trigger in Crummey trusts

Although the Crummey trust limits the withdrawal period and the amount one can withdraw, there is still one potential hitch in the plan. The children do have present interest and can spend the money.

What will keep them from spending wastefully? This is where the grim trigger strategy comes into play.

It’s hard to imagine anyone being able to easily resist the lure of free money, but a little consideration reveals a simple way to persuade your children or grandchildren to leave the money alone. If you have a large enough estate to make annual gifts to family members, odds are good that you’ll also leave a substantial amount of money to them later, whether during your lifetime or after your death. By making it clear that anyone who elects to exercise his or her withdrawal right should never expect to receive another penny from you, you’ll usually persuade everyone to exercise some self-interest and leave the money in the trust. After all, $12,000 could be a drop in the bucket compared with what any person might eventually receive. (source)

The grim trigger strategy serves as a deterrence and punishment for early withdrawals and irresponsible spending. Most parents should be able to make the strategy believable because they have a long history of showing kids they can and will enact punishment.

Some caveats to a grim trigger strategy

While a grim trigger strategy can be effective, the downside is that it is completely unforgiving. It makes no exceptions for honest mistakes or youthful indiscretion. Imagine one of your children at age 15 withdrew money and wasted it but at age 25 felt repentant about it. Do you continue to be unforgiving?

This problem and others are discussed by economist Robert Alexrod. In a fun application of computational game theory, Alexrod set up a tournament in 1984 to test various strategies for a repeated Prisoner’s Dilemma (a game with incentives similar to the repeated gift-giving game). Grim trigger did not fare very well. In the first round it ranked 7 out of 14 submitted entries. In the second round, it ranked 52 out of 62 submitted entries.

Here is what Alexrod thinks about the strategy:

In sum, Grim Trigger seems like a good idea, but isn’t. It does offer the maximal incentive for the other player to completely avoid defection. But if the other player doesn’t know that it is facing Grim Trigger, it can’t adjust its behavior until it is too late.

Any experimentation (or noise) will end in trouble for both sides. Thus in a world of more or less sophisticated players where you can observe the other’s behavior but can not know its strategy in advance, Grim Trigger is likely to be a poor performer. (source)

Key lessons

• A grim trigger strategy can encourage cooperation
• It’s crucial the other side knows you are playing grim trigger
• The biggest problem is that a grim trigger strategy is unforgiving
• A Crummey trust is an instructive example where someone might use a grim trigger strategy