Tax Software 2008: A Big E-File Freebie

— -- Given the state of the economy, the biggest news in tax preparation software this year is something many people believe is long overdue: The ability to prepare and file your federal tax forms electronically, completely free of charge--regardless of how much or how little you make.

If you prefer a more user-friendly tax preparation and filing experience, the usual suspects are back, led by Intuit's market-leading TurboTax and its archrival, H&R Block's TaxCut, both with renewed emphasis on the Web versions, which last year attracted more customers than their desktop software counterparts (watch for our forthcoming reviews of the top five tax prep sites).

For the freebies, thank the IRS and the Free File Alliance (the tax software industry group working with the IRS to reach government goals on electronic filing)--but be aware of their limitations. If your adjusted gross income exceeds $56,000, you won't be getting the kind of tax prep software you've known--so, no interview or context-sensitive help. And while the tax services that participate in the Free File program offer state tax preparation and filing, they don't do it for free.

Still, for the first time, anyone can fill out and electronically file (e-file) federal tax forms--electronic versions of the same government paperwork you can pick up at the post office, complete with IRS instructions--for free. The forms have been available online for some time, but previously you had to print them out and mail them in. It's the ability to e-file them that's new.

If your adjusted gross income is $56,000 or less (which, according David R. Williams, director of electronic tax administration for the IRS, applies to some 90 million people, or 70 percent of taxpayers), then you can simply go to the IRS Free File page for help in choosing from some 20-odd tax prep packages available free to those who meet the means and other tests. As usual, each tax software vendor gets to identify eligible segments of the population--some will limit their offers to college kids, seniors, or servicepeople, for example--so no single program is available to more than 50 percent of the population. That's to ensure that no single tax software company gets stuck with handling all Free File users.

Also, all participating programs must now offer, as a minimum, a core collection of 24 key tax forms. In the past, Williams explains, some would-be Free Filers dropped out because the program they'd chosen lacked a certain form. The 24 forms all programs must have should cover the vast majority of tax scenarios, Williams says.

It's no secret that the six-year-old Free File program came into being to prevent the government from offering free tax prep and e-file software. The tax prep software industry has managed to preserve a fairly lucrative business (getting wealthier people to pay for software and electronic filing) by agreeing to provide free software and filing to lower-income customers in order to help the IRS reach its goal (set in a 1998 law) of getting 80 percent of all returns filed electronically. This would save the IRS money: The agency pegs the cost of processing a paper return at $2.87, compared with 87 cents for an electronically filed return. But Williams says e-filing doesn't just help the IRS. "It has always been faster, more accurate, and more convenient for taxpayers," he says.

Still, the 80 percent goal remains elusive, although progress has been made. A recent IRS report states that a record 60 percent of returns were filed electronically during last year's tax-filing season. But rates of adoption for electronic filing are slowing--and reaching the target level will be unlikely under current conditions, the report says.

The report describes research findings on who does and doesn't file electronically. For example, although 99 percent of third-party tax preparers (accountants and other professionals) use computers to prepare returns, just two-thirds of those returns are filed electronically. And only 5 million people used the Free File program last year, a small fraction of those eligible.

One of the most interesting parts of the IRS report is its list of possible strategies for upping e-file participation. These include increased marketing efforts (both for e-filing in general and for the Free File program); expansion of Free File to include more taxpayers (although the IRS worries that this might just draw people who now pay to file electronically rather than current paper filers); new incentives such as extending the tax payment deadline for e-filers beyond April 15; and even outright cash payments.

The lure of Free File is undeniable as tax prep and e-file fees creep up. For this year, Intuit initially announced that customers for its market-leading TurboTax desktop software would, for the first time, have to pay to print out additional returns (previously, you could create and print out as many returns as you wished with a single copy of the software). After much user complaining and an effective PR campaign by H&R Block, Intuit withdrew the additional printout fees.

E-filing fees are included in the cost of Web-based tax prep services, which tend to be slightly cheaper than desktop software for e-filers doing a single return. However, in figuring out the costs of tax prep, don't forget to check charges for a state return (assuming you file in one or more of the 40-plus states with income tax). In some cases, a service will throw in prep and e-filing for one state for free; others charge separately and sometimes steeply. Also, although you can keep copies and import data from a Web-based return for use the following year, import and export options tend to be limited, making it difficult to switch to a new service down the line. It's usually a lot easier to transition between desktop packages.

And as with all financial services, be sure to watch out for IRS-related phishing--e-mail that purports to come from the IRS or a tax software company demanding sensitive information. This has been a growing threat in recent years, especially at tax time.