IRS Debt: Compound Interest

Hello internet, after a short hiatus I am back to share stories about budgeting concerns. Today I wanted to share a cautionary tale about owing money to the IRS. This is one of the worst budget killers in my opinion because of the way they structure the payments.

Last week the issue of taxes came up at work again. One of my coworkers found out I used to prepare taxes for soldiers when I lived in Germany, and so asked for some hints. She began by saying “my taxes are a mess and I just need to figure out a better way.” Come to find out, in a previous tax season she ended up owing around $3,000 at the end of the year and did not have that amount of money saved up to pay the bill. Therefore, she asked the IRS for a payment plan. Sounds reasonable right?

Well, here is what you need to know about the IRS and payment plans. The IRS compounds interest daily. Yes you read that correctly, interest is compounded daily. That means that the amount you owe the IRS quickly becomes more than the original debt.

In the case of my coworker, even though the IRS asked for a monthly payment of approx. $400 she never seems to catch up.

Lets do the math for this using very simple numbers for interest.

Day 1: 3,000 x 3% = 90 New Total 3,090

Day 2: 3,090 x 3% = 92.70 3,182.70

Day 3: 3,182.7 x 3% =95.48 3,278.18

We are only 3 days into the math and you can see that $278 of interest has been added to the bill. And the reality is the interest rate changes according to market conditions. I looked for a historical chart and found that the interest rate for this year is actually at 6% last year was 5% and the highest I could find was from 2001 at 9%. At these rates it becomes very difficult to ever pay off the debt.

Keep in mind there are more complex rules in play to get to this point of compounding interest and I would tell anyone what I told my coworker. Consult a tax expert. They should be able to offer some helpful ways to get the debt under control.

However, what I wanted to bring to light from a budget perspective is, make sure your tax deductions are correctly aligned and your employer is withholding the correct amount.

What I do to make sure this happens is I take my total taxes due (not refund amount or amount owed) and divide that by the pay periods in the year. On the 2018 tax form this is line 63. Most people look line 76a for refund or line 78 for amount owed. These numbers are simply a representation of how well you balanced your tax payments during the year. Line 63, total tax is what you actually owe when all the deductions and income are calculated.

If the number I find is not the same or close to what my employer is withholding I adjust my W4 so that I don’t end up with a huge balance at the end of the year. I know it might stink to get less in your check each pay day but it is sure better than owing a lot at the end of the year and risk a payment plan with interest compounding daily.

Budget Tuesday

So here it is, Budget Tuesday and I find myself with a case of writers block. Although there are many topics to write about concerning money and budgets, they just seem to escape me today.

Thus far, this whole blog has been a bit of a one sided conversation where I imagine a topic that someone would be interested in, then find experiences or articles that match that imagined conversation.

Today I say, hey internet what money/budget topics interest you? What would you like to talk about today?

Purchasing a Car: Buy or Keep the Old One?

Purchasing a car is another of life’s big expenses. The average new car cost over $30k in 2018 according to Kelly Blue Book. Now, I think we all know that the cost of a new vehicle greatly depends on the type you get and the features on the “must have” list. But no matter the price point, purchasing a car is a big decision and commitment. It only makes sense to drive the car as long as possible to get the most value for your money. However, there does come a time when it is more cost effective to buy another car.

The topic of buying a new car comes to mind today because a coworker of mine has been telling me stories about all the car repairs and associated costs for her vehicle that has 290,000 miles on it. That is not a typo internet friends, I really did say 290k miles.

In all honesty, it is not up to me to tell anyone how to spend their money, but as a though experiment it is interesting to look at when it makes more sense to buy another car.

Given the average price of a car and average interest rates, a car payment can be anywhere from 350-500 dollars per month. The price is going to depend on if you buy new or preowned. With many companies selling certified preowned cars, there are a lot of good deals to be had.

Let’s take my coworker as an example. In the 8 months I have known her she told me about that she spent at least $3,000 on repairing the car and it still has problems and overheats easily. Additionally, the car recently failed a safety inspection so more money needs to be poured into the car.

When I did a quick internet search the same car with comparable miles was valued at only $2,000. Therefore, in these 8 months she has already spent more on the car than the book value. Add in the safety issues, it might just be time to purchase a new car, in theory. Seriously, what price do you put on safety?

Back the numbers, if we look at a somewhat average car payment of $400 per month, if the cost of repairs exceeds $4,800 per year it might be time to buy a new car. In the case of my coworker, the newest batch of repairs will put her very close to this number and the year is not over yet.

The most interesting thing about the whole story is that if you ask the coworker what she has on her budget for transportation cost or car costs she will tell you emphatically that she has no car payment, it is paid for. She does not set aside money for maintenance costs so each time something comes up it is always a surprise, an unexpected hit to her monthly budget, and always a stress. If you get real about what it really cost to keep the car on the road it might be less stressful to just budget for the monthly payment.

In my case, I have not had a car payment in 6 years but I do set aside money for regular maintenance so I can make the car last as long as possible. I also think it is a good idea to set aside a bit each month so that when the time comes for a newer car, I can put a chunk down and reduce the time I have to make car payments.

The conclusion to this thought experiment in my opinion is, if your car is costing your more in repairs than a car payment it makes more sense to get a newer, safer car.

The Great American Myth: Everyone Should Own a House

One of the greatest myths in America is that everyone should own a house and if you don’t you are wasting money. There are times when owning a home makes financial sense, but there are also times when it does not. All to often people jump into purchasing a home because they think it is a good idea but they do not stop to consider the whole picture.

I can hear it now “But Cipher, didn’t you just say in your last post that you are looking to buy a home?” Yes, I did say that, however, what you need to know is I looked at the market and considered the costs before making the choice. In my last post I talked about some of the basic costs associated with the initial purchase of a home. Now it is time to dive in and talk about some of the costs associated with renting vs. owning a home.

Costs Associated with Renting

The cost of renting is often times straight forward. The renter pays an agreed upon sum that is dictated in the lease. The price is locked in by the lease, some places have laws about how much the landlord can raise the rent from year to year.  

 In many cases the maintenance of the property is the responsibility of the landlord. The renter of course takes care of small things like replacing light bulbs and the occasional Liquid Plumber, but in my experience, there are not a lot of maintenance costs.

Some common costs to rent are:

  • Rent
  • Deposit
  • Utilities (sometimes included)
  • Renters Insurance (optional but a good idea)
  • Parking Spot Fee
  • Pet Fee

The place I am currently renting actually has most of the costs rolled into one fee. I pay rent and insurance; the utilities and parking are included. I did have to put down one-month deposit at move in.

Depending on the landlord it can sometimes difficult to get your whole deposit back. Because my job requires a lot of moving, it made the most sense to rent from an economic and flexibility standpoint. My costs are predictable and I never had to worry about selling my home while trying to switch jobs.

Story time: My brother rented for several years and he kept hearing people say he was “throwing away his money” by renting. Interest rates were low and the mortgage payment would be a little less than his rent payment. Sounds good right. Well, not so much.  

Soap box time: You are not throwing away money; you are exchanging it for a roof over your head. There is value in this transaction.

The thing that my brother failed to consider when deciding to buy a home was everything he would have to do and pay for to keep the home in good shape. He purchased an older home so it should come as no surprise that there were maintenance issues. Yes, the mortgage was about $150 less per month than his rent, but when the roof started leaking the several thousand dollars needed for repairs was not so easy to come up with. Even without big ticket items like a roof, there were several sneaky expenses that more than made up for the $150 “savings.”

Read on and you will see some of the costs my brother failed to consider.

Costs Associated with Ownership

The cost of owning a home is not as straight forward. The mortgage is fairly easy to predict if you have a fixed interest rate. However, if the property value increases significantly that can have a huge impact on property taxes, which will increase the escrow portion of the monthly payment. In addition to these basic costs home owners need to consider maintenance fees and repair costs. Even in newer homes, if you don’t pay attention to preventative maintenance small issues will build into big issues eventually.  

Some common costs to own are:

  • Mortgage
  • Home Owners Insurance (required)
  • Home Owners Association Dues
  • Lawn Care
  • Maintenance Costs; preventative and repairs
  • Property Taxes
  • Interest Costs
  • Utilities

As you see some of the items are the same, but there is a difference in cost. Renters insurance is fairly inexpensive but homeowner’s insurance is usually more. No matter where you live one usually pays utilities but as my brother learned electricity for his apartment vs. house was noticeably more. In the apartment water and garbage were included but he paid these costs for the house.

Where I live home owners associations are very common. One friend pays about $95 a month, another pays $150, and on the extreme end a coworker pays $650 per month. In each price point there are amenities that come with the fee. Many people don’t think of this monthly cost when deciding if renting vs. owning is better. They think mortgage vs. rent.

Don’t even get me started on having to take care of a lawn. First you have to buy all the equipment, then you actually have to take care of the lawn. Or you end up paying someone to do it for you. In either case, you are still paying for upkeep that is included in many rental options.

Interest is another major expense. I have discussed this before from different perspectives. When someone asks you what you paid for something, we often give the sticker price. What we fail to consider is the amount we pay for the privilege of borrowing money.

Here is a little math for the average home price in America. Yes, I know the amount can vary greatly from state to state and even city to city.

Home Price: $266,700

Average Interest: 4.40%

Average Length of Loan: 30 Years

Interest Paid: $214,091

Estimated Mortgage Payment: $1335

Total Cost of Mortgage: $480,791

Did you really pay $266,000 for you home. NO. You paid so much more and unless the prices more than doubled most people don’t make money on houses. They are great to live in, especially long term. But a house is not a great investment. According to business insider, the average rate of return for a house is 1.3% compared to 3.375% on other investments.

Back to the soap box: you are not throwing away money when you rent.

Final Thoughts on Rent vs. Buy

Some additional things I considered when making the rent vs buy decision. Where I live a metro station is being built; the cost of homes are high but when the metro line goes in the prices are expected to jump about 20%.

I am tired of renting apartments, many of the townhomes or houses for rent are only available for a limited lease. Most people are holding onto their property so they can sell when the metro comes in. This means I will have to move again in a year or so, which is not ideal.

It does not make sense to rent now and buy after prices jump, I would probably be priced out of the market anyway. But the biggest factor is the area I now work in has a lot of jobs opportunities so I should be able to stay put for an extended amount of time. With all costs considered, now looks to be a good time to invest in a home vs. renting.

I am not saying people should not buy homes. If it makes financial sense within a well-developed budget, by all means purchase a home. For me, the timing, the budget, and the willingness to be responsible for a home has led me to make the choice to purchase.

Buying and Selling a House: The Cost of Home Ownership

https://www.zillow.com/homes/for_sale/124111451_zpid/37.505368,-77.338343,37.33809,-77.584506_rect/12_zm/1_fr/?view=public

Disclaimer: This post discusses an actual home for sale. I have the permission of the owner to use their details in this post.

Selling and buying a home is one of the biggest financial commitments a person will make. It takes a lot of planning, saving, building credit, and research to find the right home, in the right location, at the right price. In fact, housing costs is the largest predictor of cost of living from location to location. Selling a home is a large cost; especially because the seller is the one to pay the real estate commission. Much of a person’s equity in their home can be siphoned away in commission and associated fees. Even though buyers pay less fees as part of the closing costs, they still have to consider many factors.

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My friend and I are both dealing with the real estate market right now, so of course I find this an interesting topic to discuss. My friend is selling in Richmond, VA. The house looks like the after footage of a HGTV show. One would think that a beautiful move in ready home would be easy to sell. Yet, for some reason my friend is having a difficult time selling his home. The solution seems to be to lower the price, which eats into the equity of the home, and thus the available budget for the next home.

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Looking at selling a home from a budget perspective, there are many costs to consider. The commission is the most obvious.  A house listed at $370,000 is going to pay a commission of $22,200. Other fees include title insurance, sales taxes, escrow fees, and other miscellaneous fees depending on where you live. For my friend in Richmond it is going to cost about $4,000. Always assuming he does not pay any buyer fees or concessions. Add to these costs associated with making the home ready to sell, such as painting. The list can go on depending on the home. For my friend his additional costs were about $3,000. At the end of the day much of the equity in the home goes to the fees associated with selling.

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One may not always have a choice about when to sell, but if you do it is worth looking at all the associated costs before deciding if selling is the right choice from a financial perspective.  I know some people move because they just want to be somewhere different, some move for work, and others move because they have outgrown their house. Whatever the reason, it is import to consider the real cost associated with the decision.

I am also in the housing market, but I am on the buyer’s side of the transaction. I mentioned in previous posts that my old job ended because we finished doing what we were hired to do. Contracting work is like that. My new job is in a much bigger city with a much higher cost of living. What I used to pay for a spacious home in my old city won’t even get me a small apartment near where I work. This is supply and demand at play. Instead I must look farther out and for a smaller place. Okay, fair enough.

As a buyer I do not pay as many fees as the seller does, but there are fees associated with buying a home that must be factored into the budget. Recent statistics show the buyer will pay fees roughly 2-5% of the cost of the home. If we go for the middle range of 3% this cost can quickly add up in high cost housing market.  I estimate the closing cost will be at least $10,000 but probably more.  

Other things a buyer has to factor in when hunting for a home is how much of a down payment should they have, the cost of loan origination fees, and of course interest rates. As rates push higher the amount one can afford to spend on a home goes down.  The bottom line is my salary will only allow me to spend X amount on housing. If the cost of the loan is higher then I have to lower the amount I can afford to spend on the base sales price.

A while ago I wrote a post about an article that listed 30 money mistakes. One of the money mistakes was spending more on housing than one can afford. When you live in an expensive city there is not a ton you can do about affordability issues. One of the biggest questions to ask yourself is how much space do I really need. Then consider things like, how far to commute, neighborhood safety, schools if you have kids, and local amenities. I am looking in areas near the metro to help with the commute but it turns out that has a huge impact on cost.

Whether you are a buyer or seller, do your research and then take the time to build a solid budget before you jump into the complicated housing process. It might take some of the stress out of the process.

Why Companies Should Disclose Pay Information

One of the social issues that people discuss a great deal is equal pay for equal work. This debate leads to the broader issues of pay transparency in the workplace. Companies give many reasons why it is necessary to keep pay data a secret. However, Employees are beginning to crave more transparency from their employees, especially younger workers. It just might be time to let go of the antiquated concept that pay information must be a tightly held secret.

Here are many reasons a company should disclose pay information and may even benefit from being more transparent.

Potential Employees Know What to Expect

When people are looking for jobs, they spend a lot of time searching for something that matches their skill set, modifying resumes, preparing for interviews, and participating in interviews.

Companies spend a lot of time writing job postings, reading many resumes, and preparing for the interview process. All this effort, only for people to realize the job they applied for does not offer the salary they need/want.

This is a lot of wasted effort for the job hunter, and a lot of wasted money for the company. If the company simply added a pay range to the job listing potential employees would know what to expect. The company will get a list of candidates who actually want to do the job for the pay offered.

As a contractor I look for work on a regular basis. I get a job for a specific project and when my task is complete it is time to find another project. Last year I was in the job-hunting phase and applies for many positions.  On more than one occasion I applied for a job that sounded like it would be something I would like to do only to find out the pay was way less than I needed. In one case the salary was 53% less than I usually make, and they wanted me to work in D.C. Um no, I can’t take a pay cut and live in a much more expensive city.  If I had known the proposed salary up front, I could have saved us both the time and effort.

It Builds Trust

One reason for not disclosing pay data this information provides a competitive advantage for companies. A competitor could see the pay range and know exactly how much it would cost to “steal” employees. However, I would argue that employees who like their work environment, feel engaged at work, and trust they are getting a fair deal from their employer are not usually looking to jump to another company. Assuming you ignore the hubris that a person can be stolen; an employee is not property to steal…just saying.

The issue of trust is also a huge topic when it comes to the gender pay gap. A lot of this angst could be alleviated if people knew what pay was associated with which tasks. Look at the task list and then say for this type of work the company will pay between X and Y. Using this model, no matter who applies, if they can do the task they can negotiate within the acceptable range.

There are valid reasons to pay one person more than another, which is why I think a range is the way to go. One person might have a bit more experience, a degree, a certification. Another might have most of the skills but needs to have on the job training for one or two things. By all means pay the first person a little more than the second person. At least we are all in the same ballpark.

This leads to the second factor of trust. When the company knows what they will offer and the potential employee does not, the employee is negotiating blindly. The company has a significant advantage because they have all the information. Many companies take advantage of this and use it to offer as little money as possible.

The employee will eventually find out and many people feel taken advantage of and stop trusting their employer. Some people will start looking for another job, others will try to negotiate for a raise, others will silently fume and become less productive. Worst case scenario, this is a leading reason for fraud. People begin to think “the company owes me; I am just taking what I am owed.”

Less Attrition in the Workforce

In my totally unscientific opinion, I think that another reasons companies should disclose pay information is it will lead to less attrition in the workforce. I kind of alluded to this in the last section; when people feel they are being paid unfairly, for whatever reason, they start to look for the next employer.

When I was in school, we looked at how much money companies spend each year looking for and hiring new employees. It can cost a company anywhere from 10% to 30% of the salary, on average, to replace an employee. It can cost significantly more to replace an employee with a lot of responsibility or an in-demand skill set.

The funny thing is “fair” is a relative term. You might have an employee who is happy with the money they make until they find out their counterpart is paid more than they are. This is especially true when the employee feels like they are expected to do more work than the higher paid counterpart. This feeling is one reason companies try to keep pay a secret at all costs. In my opinion, if you had transparency the angst over this issue is less.

There is no one size fits all to the issue of pay transparency. Some companies are old fashioned and hold on to the policies they have had for years. Some companies think transparency is an ideal that sounds good on paper and does not work well in reality. Others embrace the idea and have had success implementing pay transparency policies. Like any idea of this kind, I think whether pay transparency works is all in the implementation. A poorly executed policy will probably backfire. A thoughtful, well executed policy just might make employees happier and trust their employees more.

This can be a touchy topic, but as always, respectful comments are welcome. What are your thoughts on the issue of pay transparency?

Budgeting and the Tax Debate

Monday was officially the deadline to file taxes for 2018 so of course there were several conversations in the office regarding this topic. The main debate was on the topic of maximizing a refund vs. trying to break even by balancing withholdings from paychecks. At first blush this may not appear to be a budgeting topic, but trust me it is.

The goal of taxes from an IRS standpoint is to have the taxpayer be as close to paying the correct amount of taxes by the end of the year as possible. When I took taxes as part of my accounting degree the professor drilled this concept into our heads. He always said, “If you get a refund at the end of the year that means you just gave the government an interest free loan.”

Okay this is a fair point, especially from an academic standpoint. However, a classmate countered with “I know it is an interest free loan but I do not have the discipline to set aside money. I let them hold on to it and at the end of the year I get a little bonus to splurge on something, maybe a vacation.”  

From a budget perspective tax withholding can have a significant impact. On the one hand, if you keep as close to the actual amount owed as possible you can maximize the amount of money you control. This can help pay bills. Under these circumstances you have to budget the extra money and save it if you want to splurge, like my schoolmate.  I can hear her now “Boring.” In my case I am usually within +- 100 of balanced. It is difficult to be exactly on target. The closest I ever got was owing $15.

On the other hand, if you like the feeling of a yearly bonus tax refund time is a favorite time of year. Saving a little each paycheck to finally add up to the amount it would take to go on a vacation does not give the same rush as getting a big sum all at once on a refund check. You still saved, you just tricked yourself into doing it.

The other benefit of having more taxes withheld from paychecks is you have a cushion when you unsure how much you will owe at the end of the year. It might be better to over withhold than to face a huge tax bill at the end of the year. Especially, if you don’t have the money when the bill comes due.  

I used to volunteer to do taxes for soldiers when I lived overseas. Some of the common reasons people would end up owing money without realizing why are:

  • You and your spouse have jobs, the pay is in a specific tax bracket. Add the income together at the end of the year and now you are in a new tax bracket.
  • Soldiers retire, get new jobs, earn retirement pay, and when all the income is added together at the end of the year, new tax bracket.
  • Forgetting to change deductions when kids leave home and they start claiming themselves on their own taxes.
  • Forgetting to change deductions when marital status changes.
  • Not realizing that you have to pay quarterly taxes on side jobs. This got the personal trainer I worked with.  Taxes for self-employed people are a bit complicated.  People don’t realize that their employer kicks in a certain amount. When you are self employed you pay both parts.

What school of thought are you from; Do you prefer to balance the taxes and keep your money throughout the year?  Or do you prefer to get the refund at the end of the year? The debate among my colleagues goes on 😊