Owning a company means investing time and money into assets that help your business run smoothly. Assets like computers and vehicles can be essential to achieving high business performance, but how do you anticipate and calculate when these investments begin to lose their value?
The straight-line depreciation method is a common way to measure the depreciation of a fixed asset over time. The method can help you predict your expenses, know when it’s time for a new investment and prepare for tax season. Continue reading to learn how to calculate straight-line depreciation and determine the value of your assets.
Why is the straight-line depreciation method important?
The straight-line depreciation method is important because you can use the formula to determine how much value an asset loses over time. By using this formula, you can calculate when you will need to replace an asset and prepare for that expense.
You can use this method to anticipate the cost and value of assets like land, vehicles and machinery. While the upfront cost of these items can be shocking, calculating depreciation can actually save you money, thanks to IRS tax guidelines.
After using the straight-line depreciation method, the IRS allows businesses to use the straight-line method to write off certain business expenses under the Modified Accelerated Cost Recovery System (MACRS).
Common instances to use straight-line depreciation
The best time to use the straight-line depreciation method is when you don’t expect an asset to have a specific pattern of use over time. Here are some examples of when to use the formula:
- Business accounting
- Preparing for tax season
- Creating an income statement
- Calculating an asset’s value
- Before making an investment
Straight-line depreciation is often the easiest and most straightforward way of calculating depreciation, which means it can potentially result in fewer errors.
The straight-line depreciation formula
The straight-line depreciation equation measures how much value an item loses over time. The method assumes a fixed asset will lose the same amount of value each year of its useful life until it reaches its salvage value. Below is what the straight-line depreciation formula looks like:
Annual depreciation expense = (purchase price − salvage value) / useful life
To help you better understand this formula, let’s define a few key terms:
- Depreciation: The decrease in a physical asset’s worth.
- Fixed asset: A long-term tangible piece of property or equipment a company owns and uses to produce revenue.
- Useful life: An accounting measure of the number of years an asset could remain in operation and help generate revenue.
- Salvage value: The estimated value of an asset at the end of its useful life. Also called scrap value or residual value, salvage value calculates an asset’s annual depreciation cost.
- Purchase price: The total cost of an asset, including shipping, taxes, and any applicable fees.
By estimating depreciation, companies can spread the cost of an asset over several years. The straight-line depreciation method is a simple and reliable way small business owners can calculate depreciation.
How to calculate straight-line depreciation
Now that you know what straight-line depreciation is and why it’s important, let’s look at how to calculate it.
Step 1: Calculate the asset’s purchase price
The purchase price refers to the total cost of an asset. You can calculate an asset’s purchase price by adding the following figures together:
- Price: the original price you purchased the asset for
- Shipping: any fees that relate to the delivery of your asset
- Taxes: an additional fee that reflects a percentage of the asset’s price
- Maintenance: costs associated with maintaining the asset
- Any applicable fees: anything that adds to the cost of the asset
After you gather these figures, add them up to determine the total purchase price. Now it’s time to calculate the asset’s life span and salvage value.
Step 2: Determine the asset’s life span and salvage value
You can calculate the asset’s life span by determining the number of years it will remain useful. It’s possible to find this information on the product’s packaging, website or by speaking to a brand representative.
Next, you’ll estimate the cost of the salvage value by considering how much the product will be worth at the end of its useful life span.
Step 3: Subtract the salvage value from the purchase price
Now that you have calculated the purchase price, life span and salvage value, it’s time to subtract these figures.
Subtract the asset’s salvage value from the purchase price. This number will show you how much money the asset is ultimately worth while calculating its depreciation.
Step 4: Calculate depreciation expenses
Once you understand the asset’s worth, it’s time to calculate depreciation expense using the straight-line depreciation equation.
This means taking the asset’s worth (the salvage value subtracted from the purchase price) and dividing it by its useful life. This number will give you an asset’s annual depreciation expense.
Step 5: Divide by 12 for monthly depreciation (optional)
If you want to take the equation a step further, you can divide the annual depreciation expense by twelve to determine monthly depreciation. This step is optional, however, it can shed light on monthly depreciation expenses.
With these numbers on hand, you’ll be able to use the straight-line depreciation formula to determine the amount of depreciation for an asset on an annual or monthly basis.
Accelerated depreciation vs straight-line depreciation
The straight-line depreciation method is not to be confused with accelerated depreciation. The two systems differ in a few ways:
- Accelerated depreciation: an assets loses value fasterin th beginning of its lifespan and depreciation begins to slow down over time.
- Straight-line depreciation: an asset loses value at the same rate over time.
Now that you know the difference between the depreciation models, let’s see the straight-line depreciation method being used in real-world situations.
Straight-line depreciation examples in the real world
Straight-line depreciation is used in everyday scenarios to calculate the with of business assets. To get a better understanding of how to calculate straight-line depreciation, let’s look at a few examples below.
Tree removal service example
Let’s say you own a tree removal service, and you buy a brand-new commercial wood chipper for $15,000 (purchase price). Your tree removal business is such a success that your wood chipper will last for only five years before you need to replace it (useful life).
You believe after five years you’ll be able to sell your wood chipper for $3,000 (salvage value). Here’s how you would calculate your wood chipper’s depreciation using the straight-line method:
Annual depreciation per year = (Purchase price of $15,000 − salvage life of $3,000) / useful life of five years
Annual depreciation per year = $12,000 / 5
Annual depreciation per year = $2,400
According to the straight-line method of depreciation, your wood chipper will depreciate $2,400 every year.
Fishing business example
Now, let’s assume you run a large fishing business that sets out on the Bering Sea every summer to capture fresh salmon. You buy a new vessel for $280,000 to help increase production.
According to the IRS’s standard use of life, vessels fall under the 10-year property life. Once that 10-year period is up, you believe you can sell your vessel for $70,000. Using the straight-line depreciation formula, here’s how much your fishing vessel will depreciate each year:
Annual depreciation per year = (Purchase price of $280,000 − salvage life of $70,000) / useful life of 10 years
Annual depreciation per year = $210,000 / 10
Annual depreciation per year = $21,000
When crunching numbers in the office, you can record your vessel depreciating $21,000 per year over 10 years using the straight-line method.
Real estate example
Lastly, let’s pretend you just bought property to build a new storefront for your bakery. You installed a fence around the entire plot of land, which falls under the 15-year property life. The initial cost of the fence was $25,000, and you think you can scrap the wood for $3,000 at the end of its useful life.
Using the straight-line depreciation method, here’s how much your fence will depreciate each year:
Annual depreciation per year = (Purchase price of $25,000 − salvage life of $3,000) / useful life of 15 years
Annual depreciation per year = $22,000 / 15
Annual depreciation per year = $1,467
After building your fence, you can expect it to depreciate by $1,467 each year. Additionally, you can calculate the depreciation rate by dividing the depreciation amount by the total depreciable cost (purchase price − estimated salvage value).
In this case, the depreciation rate of your fence will be 6.67% ($1,467 / $22,000 = 0.067 x 100). With an asset’s depreciation rate, you can create a depreciation schedule to see how much value an asset loses each year.
Other depreciation methods to consider
The straight-line method of depreciation isn’t the only way businesses can calculate the value of their depreciable assets. While the straight-line method is the easiest, sometimes companies may need a more accurate method. Below are a few other methods one can use to calculate depreciation.
The straight-line depreciation method differs from other methods because it assumes an asset will lose the same amount of value each year.
Double-declining balance method
With the double-declining balance method, higher depreciation is posted at the beginning of the useful life of the asset, with lower depreciation expenses coming later. This method is an accelerated depreciation method because more expenses are posted in an asset’s early years, with fewer expenses being posted in later years.
This approach calculates depreciation as a percentage and then depreciates the asset at twice the percentage rate.
Units of production method
Manufacturing businesses typically use the units of production method. This method calculates depreciation by looking at the number of units generated in a given year. This method is useful for businesses that have significant year-to-year fluctuations in production.
If your company uses a piece of equipment, you should see more depreciation when you use the machinery to produce more units of a commodity. If production declines, this method lowers the depreciation expenses from one year to the next.
Streamline your accounting and save time
You can use the straight-line depreciation method to keep an eye on the value of your fixed assets and predict your expenses for the next month, quarter, or year.
If you’re ready to take your business performance to the next level, consider investing in accounting software that tracks your income and expenses.
This article originally appeared on the QuickBooks Resource Center and was syndicated by MediaFeed.org.
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8 tax new tax benefits that rolled out last year
The much-awaited SECURE 2.0 Act of 2022 was signed into law on Dec. 29, 2022. The Act creates more tax savings for employers and employees, alike, and expands access to a work-sponsored retirement program to many employees.
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The new Starter K provisions allow employers that have never sponsored a retirement plan to set up a simplified 401(k)—named the “Starter K.” Under this new plan, employers will not be required to contribute, and employees will be automatically enrolled at 3% of pay. However, contribution limits are much lower for employees than a traditional 401(k). Beginning in 2024, employees can contribute a maximum of $6,000, with a $1,000 catch-up for those 50 or over.¹ In exchange for lowering the deferral limit, employers do not have to worry about annual ADP, ACP, or top-heavy testing.
The Starter K becomes a great option for a small business that cannot afford the administrative complexities and heavier price tag of a regular 401(k), but still want to give workers an opportunity to save for retirement. And especially in states that require an employer-sponsored retirement plan, the Starter K could be a great private alternative to the potentially somewhat clunky State-IRA options. The American Retirement Association estimates that 19 million additional workers will gain access to a workplace retirement plan with this provision enacted. Moreover, the plan will reduce racial inequity in the retirement space, as Black and Hispanic workers would see a a 22% increase in access to workplace retirement plans.
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Another of the more exciting provisions is the creation of Pension-Linked Emergency Savings Accounts (PLESAs), which are employer-sponsored accounts linked to a retirement plan, where non-highly compensated employees can withdraw more regularly and without penalty.
The account is to be set up as a designated Roth account and invested in highly liquid assets, such as a money market fund. Contributions must cease after the account balance reaches $2,500, and any additional savings goes to the Roth 401(k) account instead.
Participants can be auto-enrolled at 3% of gross income as an after-tax elective deferral. Employers need to match the funds with whatever 401(k) matching formula is used, and the match would be contributed to the 401(k) account. Participants can withdraw funds at least once monthly. They will also be able to replenish funds back up to the $2,500 cap at any time.
Not only do PLESAs have the potential to help alleviate the nationwide problem of households not having enough liquid emergency funds; they will also encourage retirement plan participation, since one of the main reasons for not participating is the fear of needing liquidity if an emergency were to occur.
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While not a new plan option, the new rules will now require all newly established 401(k) and 403(b) plans to include automatic enrollment, along with auto-escalation, as default features beginning Jan. 1, 2025. The initial auto-enrollment default must be between 3% and 10%, and the rate must increase every year by 1%, until the participant hits at least a 10%, and no more than 15%, contribution.
Employees can opt out or set their own contribution rate at any time, but this will ensure those who don’t take any action will automatically begin to save for retirement. There is an exception for small businesses with 10 or fewer employees, new businesses, church plans, and governmental plans. Plans established as of Dec. 23, 2022 are also grandfathered.
The Senate noted that auto-enrollment increases participation among younger, lower-paid employees and the racial gap in participation rates is nearly eliminated. No doubt that participation should significantly increase—however, given that auto-enrollment will be a requirement, there’s a chance the current $500 auto-enrollment tax credit for new plans will disappear as that incentive will no longer be needed. At Guideline, we believe that auto enrollment provides many benefits to employers and employees, which is why all eligible participants are automatically enrolled in their employer-sponsored 401(k) plan if they don’t either self-enroll or opt-out by the prescribed deadline.
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Increase in tax credits
Though auto-enrollment credit might eventually go away, SECURE 2.0 provides a wealth of additional tax incentives over the current ones.
The original SECURE Act, passed in 2019, increased the Retirement Plans Startup Cost Tax Credit to the greater of $500 or the lesser of either $250 for each eligible non-highly compensated employee (NHCE) or $5,000. The credit applies for up to three years and is limited to 50% of eligible startup costs, which include ordinary and necessary costs to set up and administer the plan, as well as educate employees about the plan.
Employers qualify for this credit if they have 100 or fewer employees, have at least one plan participant that is an NHCE, and have not sponsored a plan in the last three years.
SECURE 2.0 removes the 50% cap for qualifying businesses with up to 50 employees so that 100% of startup costs could potentially be covered. The maximum credit is still $15,000 over three years.
SECURE 2.0 also provides an additional credit for employer contributions, up to $1,000 per employee. Employers with up to 50 employees are eligible for the full credit, which is phased out for employers with 51-100 employees.
The new tax credit provisions, effective as of Jan. 1, 2023, significantly increase the benefits of starting a 401(k) plan for the smallest businesses and also provide monetary incentive for small businesses to start a safe harbor plan, which can make plan administration less of a burden in the long run.
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SECURE 2.0 turns the current Saver’s Credit into a saver’s match. Currently, individuals under a certain income threshold who save into their retirement account are eligible to receive a non-refundable tax credit of 50%, 20%, or 10% of their retirement contributions up to $2,000.
The new provisions require that this credit be deposited directly into a retirement account. The amount of the credit will remain the same based on prior requirements and again is phased out depending on income.
This provision is a clever way of ensuring that the saver’s retirement tax benefit is actually contributed towards their retirement and helps to boost retirement savings for those in a lower income tax bracket. However, it won’t be effective until after 2026—likely to figure out administrative challenges in how to deposit those funds.
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There is also good news for those paying off student debt. Starting in 2024, employers will be able to match payments employees make toward qualified student loans. The match must follow the same formula and vesting schedule as whatever is tied to the retirement plan, and the contribution will be deposited into the employee’s retirement account.
Employers will be able to rely on the employee’s certification that loan payments are being made. The student loan participants may also be tested separately from the rest of the plan for ADP purposes.
The new rules will allow employees with large student debt to still capitalize on any matching contributions offered by their company to help them keep on track for retirement.
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Catch-up contributions
The Act includes some nice adjustments for later-stage participants, beginning with an increase in catch-up contributions.
Starting in 2025, the catch-up contribution limit will increase to $10,000 for employees aged 60 to 63. The limit will be indexed for inflation every year, and—here’s the catch—all catch-up contributions will now be required to be Roth, unless the employee earns $145,000 or less annually.
Some have mixed feelings about this provision. On the one hand, employees nearer to retirement are allowed to save even more in a tax-advantaged way, but on the other hand, the immediate tax benefit gets taken away from them. Older participants generally prefer to save money on a pre-tax basis if possible, as the tax advantage of Roth contributions increases exponentially the longer you hold money in your account.
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Another favorable provision for later-stage savers is the required minimum distribution (RMD) age increase to 73, beginning on Jan. 1, 2023. The current RMD age is 72. The RMD age will also increase to age 75 in 2033. And starting in 2024 designated Roth contributions will no longer be included when calculating the RMD amount.
The late withdrawal penalty is also decreased to either 10 or 25% (down from 50%), depending on how soon the error is corrected. The provisions provide a logical adjustment to required distributions as life expectancy increases, allowing individuals more time to determine their best withdrawal strategy for tax purposes.
On the whole, we are excited about the new SECURE provisions and believe there will be an overall positive impact on the retirement readiness of American workers. Guideline looks forward to supporting the required immediate changes and adjusting our offerings in the future to accommodate the rest.
This article originally appeared on the Quickbooks Resource Center and was syndicated by MediaFeed.org.
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