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.


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 😊

The Pitfalls and Benefits of Credit Cards

When it comes to budgeting and being mindful of money, credit cards can have a huge impact on the bottom line. Many places don’t take checks any more and sometimes people look at you like you are crazy when you slow down the line by paying cash. I can hear them thinking “aw she is cute paying with her little pieces of paper.” Credit cards make paying for things simple and fast, but they can make us less aware (mindful) of our spending habits.  Let’s take a look at some of the pitfalls and some benefits of credit cards.

Points Programs

Every day we are bombarded with credit card adds that talk up the benefits of their points programs. If you use their card you will get cash back, airline points, hotel points, or member exclusive access to certain events. This all sounds wonderful but what are these benefits really costing you.

One popular program offers you 1.5% cash back on every purchase. Sounds great, free money! Maybe, maybe not. The company is counting on you not paying off the credit card every month so they can charge you interest, which is much higher than 1.5%, that is pennies to them.  I have seen interest rate ranging from 6% for people with the best credit scores, 14% on average, and up to 25%. If you carry a modest balance the cash back still does not put a dent on the low end 6% rate. 

One common mistake people are tricked into, especially with advertising, is putting things on their card just to earn rewards. Sure, you might earn a free plane ticket here and there but if you are paying interest on that purchase that “free” ticket is costing you more than if you just purchased the ticket outright.  If you are making a purchase just for the reward, maybe think twice…can you pay the balance before the next billing cycle. If the answer is no, ask yourself, would I make this purchase if no reward was involved?

I fully confess, I love my points programs. Particularly the program tied to the card I use for business travel. I know that when I put my hotel, car, plane ticket, and any other business costs on the card I will be reimbursed for those charges before the next payment cycle. Therefore, I do get free money.

Carrying a Balance

There are times when an unexpected expense comes up or we just need to make a large purchase. It is great to have a credit card to facilitate the process. Another reason a credit card is great is for online shopping. There are some great deals to be found or products you just can find locally but you need some form of digital payment. Many of the sites I use let me save my payment and all I have to do is click a button and my purchase is on its way. These are all reasons credit is great.

The danger is in carrying a balance. A few years ago, I was helping someone with a budget and they had maxed out their American Express card; these cards are not meant to carry a balance. He was being charged 25% interest on a balance that was over 20k. Think about the math on that for a minute.  That is $5,000 interest in one month. Each month that number grows and it becomes more difficult to get out of that hole.

But let’s take a more common example. Pretend you carry a $2,000 balance at the lower end of the interest scale, say 10%. This will cost you $200 interest; the minimum payment is 50.00. If you pay just the minimum next month you owe $2,150 with interest of $215. And so it goes until you buckle down and pay the balance off.

 I get it, sometimes the unexpected happens and you have to use your card, but I suggest you pay the balance as quick as you can.

Not Paying off Everyday Items

I put a lot of stuff on my card, from gas, groceries, cell phone bill, gym fees, to lunch when I don’t feel like packing my own. It is just easier to have all the charges go to one place and then I pay the balance every payday. This just simplifies my life, especially when I am on the go a lot. The biggest trap I see people fall into not paying off the everyday purchases.  

Even if you have to carry a balance for a large purchase, my advice is to make sure you keep track of the ordinary purchases and make sure you pay them off each month. This way the sneaky interest monster does not grab you and put a dent in your financial goals.

Speaking of everyday items and online shopping, when I lived overseas, I met a lot of people who did not have any credit cards. Where I lived, they were not that common and many local businesses did not accept cards. A friend of mine asked where I purchased the book I was reading; I told her Amazon. She was sad that she could not get the book. At first, I misunderstood and thought she meant they will not deliver to our location, so I quickly told her “no Amazon does deliver here.” The lady corrected me, she said “I do not have a credit card so I have no way to pay for this item.” Being an American from a consumer/credit culture this was new to me. Long story short, I bought the book for her and she just gave me cash.

As Americans, we do live in a credit culture, which can be a good and a bad thing. Having a credit card makes it so we have access to many things at the click of a button. The pitfall is that it is easy to spend beyond our means and the things we buy end up costing way more than we think. As always, there is no judgement, I am just advocating for mindful spending.

When Should We Begin Teaching Children About Money?

Recently the local news station was doing a segment about how game companies intentionally make children’s games addictive. The reporter gets a father and child on TV for an interview about how the child charged about $3,000 worth of game items to the father’s credit card. When the child is interviewed, he is gleefully telling the reporter how he just clicked the button every time the game gave him the choice to get another boost, coins, or extra lives. The news story got me to thinking, when should we begin teaching children about money?

The child on television is talking to the reporter in a way that made me think this the child still does not really understand that they did something wrong. The tone, body language, and words chosen all point to the kid thinking “I had fun with the game, my dad got mad for some reason, and now I get to talk about it on TV. Look at me on TV.”  If this is really the case and not some kind of dramatization or coaching off screen, someone has failed this child if they spent $3k on a game in one month and still does not understand there is a consequence for this action.  

It dawned on me that the reason I know so many adults who struggle with managing money is because they were not taught as children how to manage money. Therefore, I began talking to my friends and family to get their opinion about what age is a good age to start teaching kids about money. I got a wide range of interesting answers.

I will start with my own childhood. My parents have always been very secretive about money; it is very taboo…we just don’t talk about those things. I knew we did not have a lot and that after my step-dad was injured at work we needed help. I never knew how bad it was exactly but I did know I got free lunch at school because my parents qualified for some assistance.

When I was 17 a friend of mine was taking business economics as an elective and the class had a personal finance month. She began telling me all about the things she learned in class. I realized I did not know anything about managing my money.  I had a job, cashed my paycheck at the bank that issued the check, and gave my dad a little money for my car insurance.  At 17 maybe I should have known a bit more about how to manage money.

My coworker started having conversations with her child when the child was in elementary school. My coworker started with small conversations like teaching her child one does not always get what they want when they want it. Things have a cost and sometimes we have to wait to purchase something and/or save for it. As the child got older my coworker gave her kid a prepaid debit card as a way to teach the daughter how to manage a small amount of money. As the child grew the complexity of the money lessons grew.

Another friend takes a middle ground on this issue. He thinks that you should not start money conversations when children are too young. Just let them be kids as long as they can before putting the pressure of the world on them. This friend is of the school of thought that all you need to teach a children responsibility is  give them chores and paying a small allowance. This way they learn you work for what you have. Then when the child is 14 or so you can teach them about money.  

That is all well and good in generations gone by. But today companies actively build marketing programs to target children. They are bombarded with input at a very young age so my opinion is we need to start teaching them small lessons at a young age. The child does not need to know every detail of the family budget.  But it is a good idea to teach a child that they cannot just click a button and get something anytime they want it.

This is a complex issue and can become emotionally charged. Most parents I know do the best they can by their children and work hard to provide their child with the things they need. However, I think we should consider that one of the things a child need is lessons and boundaries. Teaching a child about money is a life skill that can make a world of difference throughout their whole life.

Any opinions out there; what is a good age to start teaching a child about money?

Respectful comments are welcome. Names are optional to post a comment.  

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Impulse Spending: Lottery Fever

The Powerball has climbed to $625 million for the drawing on Saturday, March 23, 2019. The higher the prize climbs the more people get lottery fever and feel the need to buy into the dream that the next big winner could be them. It is okay to dream but the question becomes, where is the line between dreaming and gambling money one cannot afford to lose?

A coworker of mine buys one ticket for every drawing no matter the size of the prize. This amounts to a modest $4 a week, and he calls it a tax on dreamers.  He knows that he is not likely to actually win anything of significance but still plays. My coworker has a rule to never buy more than one ticket; either you are going to win or you are not, but one ticket is enough. This is on the caution side of the line and dreaming.

I’ll be honest, I recently started joining my friend in the one ticket per drawing dream. But my dream is a little smaller than his, I just dream of wining the second-place prize; first place prize gets too much attention.  Overall, the cost of this indulgence is easily absorbable…but yes, it is on my budget under discretionary spending.

This week as the pot grew from $425 to $625 some of the people I work with started an office pool with a buy in of $40 per person. I read an article around the time of the 1.5 billion lottery that posed a theory that the reason people start office pools is because they want to have something to bond over. Most know they will not win, but want the camaraderie that comes with having a common dream, even if it is only for a little while.

The part that is crazy to me is hearing the individuals in the pool talking about buying additional tickets. Why do I say crazy? Well the same people buying all these tickets are the same ones who often speak about having a difficult time paying bills, or paying bills on time. They think if only they win this time all their money woes will go away. But the chances of them winning are 1 in 262 million. The reality is when you cannot pay your bills, the lottery is not likely to be your way out. This is on the side of the line where people gamble money they cannot afford to lose.

.The lottery phenomenon is interesting to me, people want to dream a little dream. Logically we know that the chances are so small that we will win, but a small voice says “it has to be someone, maybe it will be me.”  At the end of the day my perspective always comes back to budget. If you have the extra money to spend, by all means have fun. If not, do yourself a favor and avoid the impulse spending.

To all of you out there, do you dream the little dream? Or do you stay out of the game?