Life insurance is an insurance policy designed to pay out if the insured person dies. These policies were created so that if the main income holder of a household died, the payout from the policy could be used to support his/her family. Over the last 50 years, life insurance policies have greatly expanded in both form and function.  Sometimes they look more like investment vehicles than simple insurance policies.

Getting a Life Insurance Policy

As happens with most other types of insurance, the policy is very straightforward .  There is an assessment of the risk, the policy is created, monthly premiums are paid, and the insurance company pays out when something goes wrong. However, with life insurance, it can be hard for the insurance company to know the exact level of risk you present, and when “something goes wrong,” you have died, so the money is paid to your survivors instead of you.  This makes the structure of the life insurance contract is a little bit different than for other types of insurance..

Cost and Insurability

Anyone who purchases life insurance on their own will need to have their “risk of death” evaluated by the insurance company. The company typically looks at factors like personal and family medical history, how healthy and in-shape the person is, and whether or not the person is a smoker. Smoking is the quickest way to increase the cost of premiums. If the insurance company thinks you might die soon, it won’t agree to insure you.  Examples of issues you have that would cause concern include having previously suffered a serious illness, having a family history of serious illness, or having an unhealthy lifestyle.

Individuals can skip this risk evaluation if they are able to get group insurance, usually through their employer. With group insurance, everyone in the group pays the same premium. The insurance company makes an estimated average for the whole group.

Parties to the Contract

There are at least two parties involved with any life insurance policy, but there can be up to four.

• Policy Owner. This is the person who is responsible for paying the premiums on the policy and is the legal owner of the policy.
• Insurer. This is the insurance company, the entity the policy owner pays in exchange for life insurance coverage.
• Insured. This is the individuals whose life is actually being insured.  If this person dies, the Insurer will pay out the death benefits.
• Beneficiary. This is the person who receives the death benefits from the Insurer when the Insured dies. The policy owner can usually change the beneficiary at any time.

In some cases, the Policy Owner, Insured, and Beneficiary are all the same person.  An example is a father who purchases a life insurance policy for himself which is paid out to his estate upon death. It is more common for the Policy Owner and Insured to be the same person while the Beneficiary is someone else.  An example is a father who purchases a life insurance policy for himself while listing his spouse as the beneficiary.

The Policy Owner and Beneficiary can also be the same person with insurance covering someone else. This is common in large companies who take out life insurance policies on high-value employees.  If the employee dies, the company receives a death benefit to help offset the loss of value from the employee. This is extremely common with movie stars.

All four parties can also be different. For example, a husband may take out a life insurance policy on his spouse with the children listed as beneficiaries.

In these examples, you may have spotted an opportunity for fraud.  There have been cases in the past where people have taken out insurance policies listing someone they barely know as the insured and themselves as the beneficiary; then they murder that person to collect the death benefit. To combat this, all life insurance policies require that the Policy Owner prove that they will suffer a serious loss if the Insured dies.

Types of Life Insurance

There are several broad types of life insurance, each with different benefits and cost structures.

Term Life Insurance

Term life insurance is typically the least-expensive type of life insurance. A term life insurance policy is good only for a specific period of time, usually 5, 10, or 20 years.  Then the policy expires. Term  insurance policies are most commonly used by heads-of-household to insure themselves until they retire.  The family members are listed as the beneficiaries.  This provides financial security for a family when the main income provider dies.  If you see “low-cost life insurance” advertised, it is usually for term life insurance. The premiums for a term life policy will be fairly low for young people, but they increase with the age of the Insured.

There is a sub-type of term life insurance called Senior Life Insurance. This policy is specifically for older people and provides a very low death benefit, usually less than $50,000.  It is designed just to cover funeral costs for the Insured, alleviating that financial burden for a spouse or children.

Endowment Life Insurance

Endowment life insurance is almost the inverse of term life insurance.  It has a set maturity date, but instead of the policy maturing and the policy holder getting nothing, the beneficiary is paid out in cash, either as a lump sum or in several payments over time. These policies are often used by parents as a sort of “college savings” account for their children.  The insurance policy matures the same year as the child graduates from high school, and the payout is used to cover college tuition costs.

Whole Life Insurance

A Whole Life insurance policy has no expiration or maturity date.  It is guaranteed to remain in force for the life of the Insured, as long as premiums continue to be paid.  Premiums for a term life insurance policy usually start out cheaper and increase as the Insured ages, but a wholelife insurance policy will usually be cheaper over the lifetime of the Insured. This is because with a term life policy, your premiums are based on the chance that you will die while the policy is in force, so the older you get, the more likely it is that you will die. With a whole life policy, you keep paying into the same “risk pool” for many years. If you have a whole life policy long enough, the insurance company has no risk at all from your death since the total amount you’ve paid for premiums will be close to your total death benefit.

Whole Life Insurance policies often have extra “riders” or benefit packages which pay out double or triple in the case of certain types of death. For example, a typical death benefit is paid out after someone dies of an illness or a disease.  The beneficiary has some time to prepare for the death ahead of time. Many whole life policies will include an “Accidental Death” rider, so if the insured is killed unexpectedly, the policy pays a much higher death benefit to compensate the family for the sudden loss.

Life Insurance as an Investment

Many people treat their life insurance policies as a type of investment, and there are some very good reasons for doing this.

Investing in Whole Life Insurance

There are a wide range of whole life insurance policies, but one common feature is that they offer dividends to shareholders if the total payout from everyone insured is less than the company has collected in premiums. Since inflation causes these dividends to increase in value over time but your premium stay the same, the dividends you receive can end up being nearly as much as the total premium you pay. This means you pay almost nothing and still keep your insurance.

Whole Life policies also have a cash value, which can be used for two things:

1. You can take a loan out from your whole life policy tax-free, up to the cash value of the policy.  If this loan is not paid back before you die, the amount you owe is subtracted from the death benefit paid to the beneficiary.
2. If you cancel your policy, you can get a percentage of this cash value back as a “Surrender Value.”

The cash value will continue to increase the longer you have your policy, so it is common for whole life policy holders to use the tax-free loan from their cash value to help with buying a house or making other large purchases.

Investing in Endowment Life Insurance

An Endowment policy is a life insurance policy which pays a lump sum at maturity or when the Insured dies.  Typical maturities are ten, fifteen or twenty years.  It is common for endowment life insurance to be used as an investment vehicle to save for college or other large expenses. However, endowment life generally offers similar growth rates as a normal savings account.

Endowment policies are often sold as a way to force extravagant spenders into saving.  The policy combines a savings account and a term-life policy into one package.

Investing in Term Life Insurance

Term life insurance in and of itself is not much of an investing vehicle, but a common approach with financial planners is to “Buy term and invest the difference.” The concept is based on the fact that premiums for term life policies are significantly cheaper than for other policies, with the only difference being that the insured receives no “cash value” at the end of the term.

Financial planners look at the math involved. If you compare the cost of an endowment policy with a term policy, the cost for an endowment policy is higher.  Rather than paying the higher premiums, they suggest that you get a term policy with lower premiums and invest the difference. 

Endowment policy premium – Term policy premium = Amount you can invest

If you invest the difference in premiums into a high-yield savings account, mutual fund, ETF, or other investment vehicle, you will probably have more cash at the maturity date. The same is even more true if you compare term premiums to whole life premiums. The only disadvantage in this approach is that you need to make a point to save that difference, which can be an issue for many individuals.

Whatever type of life insurance policy you choose, the safety provided through life insurance is an extremely important part of any person’s financial future.

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[qsm quiz=123]

Challenge Questions

1. List all the different types of Insurance mentioned in the text above.
2. Why might someone consider a Life insurance policy?
3. How can Life insurance be an investment?
4. Would you consider a Life insurance policy later on in your life? If so why? If not, why not?

Homeowner’s Insurance is a broad type of insurance coverage designed to cover a home, its contents, and the property it sits on. This insurance is very broad, wrapping many different types of coverage into one package.

If you want to take out a mortgage on a home, the institution you borrow from will probably require you to have some level of homeowner’s insurance. They want to make sure that if there is a disaster, they do not lose their collateral on the loan. Homeowner’s insurance is like a broader form of renter’s insurance – it is a combination of property insurance and liability insurance.

History of Homeowner’s Insurance

What we now call “homeowner’s insurance” started in the 1600s as insurance against homes burning down in a fire.  It was created in direct response to the Great Fire of London. In the era before we had public fire fighters, private insurance companies would sell fire insurance to homeowners. That insurance company would then have its own staff of fire fighters who would put out fires at any insured home. There were many examples of the fire fighters arriving to a scene of a fire at an uninsured home, or at a home insured by another company, and just letting the home burn until the owners paid the company a hefty fee.

By the 1700’s, insurance companies began pooling resources into public firefighting stations. In America, Benjamin Franklin worked to popularize the notion of adding coverage for the actual damage caused by the fire, instead of just paying for firefighters. Throughout the late 1700s and 1800s, more types of property insurance were created and sold by insurance companies, including insurance against theft and burglary, insurance against water damage and weather, and insurance against someone getting injured on your property, known as liability insurance.

By the middle of the 20^th century, most insurance companies bundled these separate policies together into a single “homeowner’s insurance” package. The type of coverage that was offered was standardized in 1950, but it has continued to evolve since then.

Types of Homeowner’s Insurance

There are two broad categories of homeowner’s insurance, named after the type of coverage provided. 

Named Perils

or loss to the insured home or property is caused by anything other than one of the listed risks, the insurance will not cover it. Named perils policies represent the minority of homeowner’s insurance policies sold.  Because the coverage is so limited, most homeowners prefer more comprehensive coverage. There are two types of named perils coverage:

H01 – Basic

This is the most basic form of homeowner’s insurance.  It is used for vacant buildings or if you lapse on your insurance coverage, but the bank holding your mortgage still wants to protect their investment. It covers the following named perils:

• Fire and smoke damage
• Lightning
• Windstorm and hail damage
• Explosions
• Vandalism
• Vehicle damage

H02 – Broad

This is a slightly more common type of insurance, which covers several additional named perils.

• Everything from H01
• Burglary/break-ins
• Falling objects like trees
• Collapse from ice and snow
• Damage from frozen pipes
• Accidental water damage
• Damage caused by power surges

All Risk

All risk coverage is the opposite of named perils.  It covers all damage unless it is specifically listed as an exception. This type of coverage is used much more by homeowners, but policies can vary quite a bit in terms of the specific exclusions. There are some types of damage that are almost universally excluded from these policies, so homeowners will need to purchase separate insurance policies for these exceptions to be covered:

• Earthquakes
• Floods
• Power outages
• Neglect
• War
• Nuclear disasters
• Damage the homeowner causes on purpose

What Does a Homeowner’s Policy Cover?

A homeowner’s insurance policy has four specific types of coverage.

1. Structural Coverage – This covers the floor, walls, foundation, and other parts of the building itself.
2. Material Coverage – This covers the personal property items contained within your home.  As with renter’s insurance, it is recommended that you walk through your home with a video camera at least once a year, pointing out any possessions that have significant value. Some homeowner’s insurance policies require an explicit list of the material possessions covered.
3. Loss of Use Coverage – If your home is damaged and you need temporary lodging, this type of coverage will pay for the hotel nights while the damage is repaired.
4. Liability Coverage – This protects the homeowner in case a guest is injured and sues for damages. Liability coverage is the biggest source of claims on homeowner’s insurance policies.

Types of Reimbursement

There are two types of reimbursement the homeowner can choose from when filing a claim. 

1. Replacement Cost Value– If you choose this option, the insurance company will replace whatever was destroyed with a brand new item, and they will pay the full repair cost of anything that was damaged. This option is more expensive, so your insurance premium will be higher to reflect your choices. .
2. Cash Value – If you choose this option, the insurance company will pay you for the current value of your item.  For example, if three years ago you purchased a television for $1200, the TV has depreciated in value, so right now it may only be worth $700.  The insurance company will pay you the $700 that the TV is currently worth.  Think of the cash value as the purchase price you would set for these items if you were selling them at a garage sale.

Coverage Limits

All homeowner’s insurance policies have limits.  The limit is the maximum the insurance company will pay for a certain occurrence or claim.  For example, most policies include $100,000 of liability coverage, so if someone gets hurt on your property and sues you, the insurance company will only pay out up to that limit.

Different parts of your property include different coverage limits.

• The structure of your primary dwelling (your house):  This number is the estimate of how much it would cost to rebuild your home based on current construction costs and the square footage of your home.
• Other buildings on your property, like a shed or garage:  This number is calculated as percentage of your primary dwelling, so if you have a 60% limit on secondary buildings and your house is covered up to $100,000, your garage would be covered up to $60,000.
• Personal possessions:  Coverage for your belongings is also calculated as a percentage of the insurance on your dwelling. 

How Much Will It Cost Me?

Homeowner’s insurance can be expensive compared to renter’s insurance, depending on your level of coverage. According to the National Association of Insurance Commissioners, the average annual homeowner’s insurance premium was $1,192 in 2019. 

Like all insurance policies, your choices increase or decrease your insurance premiums.

Increasing Premiums

The biggest factors increasing your premiums relate to your liability coverage – most payments insurance companies have to make is because someone is suing the homeowner. These items will probably see your rates go up the fastest:

• Dog Bites. If you have a dog that bites someone, your premiums will immediately increase. This is the single most common reason why homeowners file insurance claims – their dog bites someone, who then sues for damages.
• Slip and Fall claims. If someone is injured on your property from a “Slip and Fall” (the second most common type of claim), your premiums also might jump, especially if it is more than once in a 3 year period.
• Mold and water damage. Mold is extremely expensive to repair, so much so that some insurance companies have dropped it from their policies entirely (this is something you should confirm with your insurance company before signing). If you have one mold or water damage claim, insurance companies might raise a red flag that more might be coming in the future due to aging plumbing or improper repairs.

Decreasing Premiums

Premiums swing both ways.  Here are some ways to get your premiums to decrease over time.

• Increase your deductible. Increasing your deductible means that you are agreeing to pay more before asking the insurance company to pay their portion.  The amount of your deductible and the cost of your premium have an inverse relationship.  The higher your deductible, the lower your premium. Another option to consider is to pay out-of-pocket for smaller damages and not filing a claim at all.  If you file too many claims, your premiums\ will definitely increase. 
• Reduce your coverages. Many policies will over-insure your belongings, such as jewelry, so you can request that certain items be removed to reduce your premium before you sign.
• Shop around. Like all insurance policies, you will benefit from shopping around once a year to find better terms. Companies change the way they categorize risk and the way they group customers into similar pools, so you could end up saving hundreds of dollars just by checking around occasionally to see if other insurance companies classify your property differently.

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This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

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[qsm quiz=117]

Challenge Questions

1. What is the purpose of homeowners insurance?
2. Give examples of the type of things that a homeowner policy will cover?
3. What is meant by coverage limits?
4. In your own words and with examples, explain what a deductible is.
5. What should you do when looking for insurance?

Renter’s Insurance is taken out on property you rent to insure against damage or loss. Renter’s insurance works in a similar fashion to homeowner’s insurance.  Homeowner’s insurance is designed to cover damage to a home’s interior and exterior, the theft of possessions, and personal liability for harm to others, for example if someone fell down your porch steps and sued you. 

As a renter, it may seem like the landlord would have you covered, but this is only partly true.  For example, if there is a fire at your apartment building caused by one of your neighbors, your landlord’s insurance would cover the repairs to the building, and his possessions (like any appliances of furniture provided in the rental units), but it would not cover any of your personal items that were destroyed.

Most renters think their items are not worth very much, so purchasing renter’s insurance isn’t a priority to them.  But when renters actually take the time to calculate the replacement cost of all of their items, the totally is usually over $20,000.  Would you have $20,000 in the bank to replace everything you own?  Probably not.  This is why renter’s insurance is important.

What Does Renter’s Insurance Cover?

Renter’s insurance applies to most events in which your personal property is damaged or stolen. This includes fires, plumbing leaks, lightning damage, items stolen during a burglary, items damaged by vandals or rioters, and items broken due to cold or hot weather. Renter’s insurance can also protect you if a guest gets injured on your property and wants to sue you.

There are three main areas of protection you receive through a basic renter’s insurance policy:

Your Personal Property

The most commonly needed type of renter’s insurance coverage is coverage of possessions in case of theft or damage.  As a “best practice,” at least once a year, you should walk through your apartment or rental property with a video camera.  Video tape everything of value that you would want replaced if it gets stolen or damaged.  You will not need this video in order to get an insurance policy, but if something is stolen or damaged down the road, your video will show proof that you owned the item that now needs to be replaced.

You can also take pictures of your valuable items.  Store the pictures or the videotape in a safe place away from your home so if there is a fire or water damage, your documentation is not lost. Before the days of digital storage, experts would recommend storing your videos or pictures in a bank safety deposit box along with a copy of your insurance policy.  But you can now store the documentation in a cloud storage service like Google Drive or Dropbox so it can be accessed from anywhere.

Your Shelter

If your apartment burns down or gets damaged due to a water leak, you probably will not be able to sleep there until the damage is fixed. If you have renter’s insurance, the policy will include a clause about “Loss of Use.” This means that if you cannot use your rental apartment, your insurance company will pay for lodging expenses while the damage is being repaired.  That way you will always have a place to stay.  There is usually a daily dollar amount that they will pay for your temporary housing, so don’t book a room at a fancy hotel because you’ll have to pay the difference.

You

Renter’s insurance also acts as liability insurance for you against your guests. If you have a visitor to your home who gets injured and wants to sue you, your renter’s insurance will cover the lawsuit claim (up to a point), including legal fees.

What Rental Insurance Does Not Cover

There are a few cases where damages will not be covered by a standard renter’s insurance policy, so make sure you understand these exceptions before filing a claim. 

Floods

Most natural floods (from heavy rain and river overflows) are not covered by standard renter’s insurance policies. If you are worried about flooding, you can usually purchase an additional “Flood Insurance” policy.

Earthquakes

Just like floods, earthquake damage is not covered by default in most renter’s insurance policies but can be purchased as a secondary policy. If you are moving to a state you are not familiar with, make sure you ask if earthquake insurance is recommended for renters. It will be worth the extra cost if you need it. 

Hurricanes

While most normal storm damage, like lightning strikes and hail damage, is covered through renter’s insurance, hurricane damage is not. You will need to acquire a separate policy to cover hurricane damage.

Intentional Damage

Any damage you cause on purpose is not covered. For example, if you get angry and punch a hole in the wall or kick down a door, your renter’s insurance will not cover the necessary repairs.  If you make any fraudulent claims, such as saying that items were stolen (when you really threw them away) or that the kitchen fire destroyed your brand new laptop (when it was really 3 years old), you are committing insurance fraud which can land you in prison. 

Getting Reimbursed

If you need to file a claim with your insurance company, there are two types of reimbursement to choose from. You make this choice at the time you take out your insurance policy.  The differences are important for you to understand. Both types are subject to your policy limit.  The policy limit is the maximum amount the insurance company will pay for each claim. 

Option 1:  Replacement Cost Value

This is the more expensive option and will make your premium higher.  Replacement cost value pays you the amount of money needed to cover the replacement of your possessions at current market prices.  This means if your apartment burns down and everything inside is destroyed, the insurance will replace your items with brand new items. 

Option 2:  Actual Cash Value

This option is cheaper and it is available in more policies.  Actual Cash Value means your insurance company will estimate the current value of your items, not the price you paid when you purchased them.  For example, if you have a computer that you purchased five years ago for $1,000, it is now only worth about $500.  So the insurance company will pay you $500, not $1,000.  This is not a rip-off.  You are being paid “fair market price” for your items, just like you’d receive if you were selling them at a garage sale.

How Much Will Rental Insurance Cost Me?

The good news is that renter’s insurance is a very inexpensive type of insurance, cheaper than auto, health, or homeowner’s insurance.  A typical policy costs only about $15 per month, and it could be cheaper for young people with fewer items that need to be covered.

Depending on who you rent from, your landlord may actually require you to get renter’s insurance within a certain period of time once you’ve signed your lease.  The reason for this is simple:  If you have renter’s insurance and a disaster hits, you are more likely to simply file a claim with your own insurance company instead of trying to sue your landlord for damages.

Whatever your reason for getting it, renter’s insurance is inexpensive and incredibly valuable for every renter.

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This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

Learn More

[qsm quiz=116]

Challenge Questions

1. Why do renters have insurance?
2. List 4 examples of what renters insurance does not cover.
3. In your opinion are you for or against insurance and why?

If you drive a car, you need to be covered by some sort of automobile insurance. You have probably seen dozens of advertisements from insurance companies claiming to help lower your rates, improve your coverage, or just encouraging you to compare rates, but before you buy your first insurance policy or change insurance providers, the first step is understanding exactly how car insurance works.

Types of Car Insurance

There are several types of insurance coverage, each designed to cover different potential cost.

Liability Coverage

Liability coverage is required in most states if you want to drive. This coverage exists to pay for repairs and medical costs of any property or person damaged as part of an accident that was your fault.  If you cause property damage by running into a building or fence, liability coverage will pay for that too.

Your liability coverage does not cover you or your car. It only covers other drivers and their vehicles. This means that if you cause an accident and damage your car or get hit by another driver who doesn’t have insurance, you will be on the hook to pay 100% of the repairs and medical bills yourself.

Collision Coverage

Collision insurance helps pay to repair or replace your car if it’s damaged in an accident with another vehicle, regardless of who caused the accident.  It also covers your car if it’s damaged by another object, such as a fence or a tree.

Personal Injury Protection

Collision coverage will pay for damage to your vehicle, but it won’t cover the cost of any medical expenses you incur. To cover medical expenses resulting from an accident, you need Personal Injury Protection (PIP). PIP covers medical expenses, regardless of who was at fault in causing the accident, for both you and your passengers.  Plus, it often covers lost wages if you are unable to work until you recover.  Remember that if another driver caused the accident, his liability insurance will cover your car repairs and your medical expenses.  However, you can have your own Personal Injury Protection as well.  In some states, PIP is a required policy add-on.  This is worth the additional cost if you are seriously injured and have high medical expenses. 

Uninsured Motorist Coverage

Even though most states require auto insurance, there are still individuals who drive a car without having the needed insurance.  These drivers are called “uninsured motorists,” and because there are uninsured drivers on the road, your insurance company may require that you have uninsured motorist coverage.  Remember that the driver at fault is responsible for the bills related to your personal injury and auto repairs, but if this driver is uninsured, who pays?

Insurance companies developed policy coverage to address situations involving uninsured or underinsured drivers—one that covers physical harm and one that causes damage to your vehicle.  Bodily Injury covers you, your passengers, and pedestrians who were injured or killed by a driver who does not have insurance.  It pays for medical expenses, funeral expenses, loss of income while you recover, and sometimes pain and suffering.  Property Damage covers the costs of repairing your car, and it may also cover other property such as your home or items in your car that were damaged in the accident.  It can also cover your repairs from a hit-and-run accident where the other driver is unknown. 

Comprehensive Coverage

Comprehensive coverage is designed to insure your car for damages and repairs that are not caused by accidents, often events that are out of your control. This includes events such as theft, damage from fire, vandalism, weather damage, hitting an animal that runs in front of your car, and getting a cracked windshield.

It’s very important for you to understand that even if you have every type of automobile insurance coverage, you are still responsible for general mechanical repairs.  These will always be paid for out-of-pocket.

Tort vs No Fault

Each state regulates car insurance independently, which means that the types of insurance coverage required will be different depending on where you are located. State rules generally fall into two categories: “Tort” and “No Fault.”

Tort States

A tort state requires that someone be found at fault for causing the accident, and that driver is responsible for coving all damages.  For example, if you cause an accident at were deemed at-fault because you ran a red light, your insurance would cover the other driver’s damages including medical bills, lost wages, and property damage. Tort states require drivers to have liability insurance in order to cover harm done to others.  If the at-fault driver does not have liability insurance, he/she would be responsible for paying for the damages caused out-of-pocket.

It is possible that both drivers could be assigned blame in the accident so both share in the financial costs. For example, in the accident on January 1, Driver A was 40% at fault and Driver B was 60% at fault.  This percentage of fault will determine how much each party is required to pay for repairs and damages.

Most states are tort states. The main advantage of the tort system is that it is perceived as more fair.  The driver responsible for causing the accident (and his insurance company) is responsible for the damage he caused, no more and no less. However, if the amount of the insurance payout does not cover the costs incurred, the injured driver can sue the driver who caused the accident.  A disadvantage of the tort system is that a huge number of accidents end up in court, and the courts then need to determine who was at fault and how much to award. This is extremely expensive both in legal fees to the drivers involved in the accident and in the burden placed on the legal system.

No Fault States

The opposite of the tort system is the no-fault system. No-fault states generally do not make any effort to determine who was responsible for a collision.  The costs for repairs and medical expenses are paid solely by each driver involved in conjunction with their own insurer. Because the costs incurred in some accidents are extremely high, the state may allow an injured driver to sue the other party if costs exceed a certain level.  The court would then determine who was at fault based on police reports and eye witnesses. 

In no-fault states where drivers are responsible for their own costs, having liability coverage and uninsured motorist coverage becomes less important but collision coverage and personal injury protection are usually mandatory.

There are currently 12 states with “no-fault” regulations:  Florida, Hawaii, Kansas, Kentucky, Massachusetts, Michigan, Minnesota, New Jersey, New York, North Dakota, Pennsylvania, and Utah, plus Puerto Rico and Washington D.C. Several other states offer the option of  no-fault insurance policies in addition to tort policies.

Proponents of no-fault insurance argue that it makes filing a claim and getting compensation for repairs simpler and faster, and it removes a huge burden from the legal system.  Opponents say that it does not properly discourage drivers from behaving recklessly which often results in higher premiums.

Driving Between States

If a driver from a no-fault state is visiting a tort state and causes an accident, he/she may be on the hook to pay a significant amount to the other driver if he/she does not have sufficient liability coverage. Conversely, many tort state policies treat drivers from no-fault states as if they are uninsured motorists, so Uninsured Motorist coverage would pay for damages from an accident.

How Much Insurance do I Really Need to Have?

Liability coverage is the minimum auto insurance coverage required to drive in most states. Remember that this insurance covers the other driver in an accident that you caused.  Insurance companies may advertise that they offer the “lowest cost insurance,” catching the attention of new, young drivers and cash-strapped drivers.  However, this low-cost insurance is for liability coverage only which means you and your vehicle won’t be covered when you cause an accident.  At the other end of the scale, many so-called personal finance “experts” will advise all drivers to get the maximum amount of coverage they can afford. Following this advice means that you may be paying for coverage you don’t necessarily need.  Take time to talk to your insurance agent for guidance on how to balance the trade-offs by determining your potential risks and the right amount of coverage for you.

Deductibles and Premiums

There are many factors that will influence the cost of your monthly premium, but the biggest factor that you can negotiate is the balance between your deductible and your premium.  The deductible is the amount of money you pay first when you file a claim.  The insurance company will then pay the rest.  The premium is the amount you pay each month for your insurance coverage. 

The amount of your deductible and the cost of your premium have an inverse relationship.  The higher your deductible, the lower your premium.  This relationship allows you some control over your total insurance costs.  For example, you may want coverage for liability, collision, uninsured driver, and personal injury protection in case of a major accident.  Even with all of this coverage, by having a high deductible, you can keep your monthly premium payments lower. You may have to pay a big sum out-of-pocket if you get into an accident, but your monthly premiums could be lower than someone who only has liability coverage and a very low deductible.

What Will Raise Your Rates

Besides choosing the type of coverages you need to have and determining how to balance your premium and deductible, there are several other factors that can influence how much your insurance rates will be.

Type and Year of Vehicle

The type of vehicle you drive has a definite impact on your insurance rates. Fast sports cars have much higher insurance rates, simply because they are more expensive to repair if they get into an accident. New cars are more expensive for the same reason. You may think that having an older car seems like the best option, but insurance companies will also charge more for cars over 15 years old. This is because older cars have higher failure rates than newer cars.  Older cars are more likely to break down while on the road, causing an accident.

Crime also plays a role in how expensive your insurance might be.  If you happen to drive a model of car that thieves prefer, the cost of comprehensive coverage will be significantly more expensive for you. The most frequently stolen cars usually are not the most expensive cars.  They are the cars that can be cut up for individual parts and sold at higher rates.

Your Age and Gender

Historically, men typically get in more accidents than women do, so women usually get a bit of a break on their car insurance premiums. Younger drivers also pay more than middle-aged drivers since their lack of experience results in more accidents.  Although they’ve had decades of experience driving, retirees may see their rates increase if they are physically impacted by changes in vision or are taking certain medications.

Your Location

Urban areas have more drivers than rural areas, thus increasing the chance of collisions on your daily commute. If you live in a city, expect to pay more for insurance.

Other Drivers Using Your Car

If you have a spouse who also uses your car, you will pay more to insure your spouse. The insurance company wants to make sure that regular drivers of a vehicle have coverage too.  Before you regularly drive someone else’s vehicle, such as your spouse’s or friend’s car, see if you need to purchase insurance.  You may be considered an uninsured driver if their insurance does not cover other drivers. When you started driving your parent’s car as a teenager, most likely your parents saw a huge spike in their monthly premium.

Using Your Car for Work

If you use your car as part of your work responsibilities, such as making food deliveries or driving around for sales calls, your normal personal insurance will probably not cover you if you get in an accident on the job. You will need a special class of professional insurance in order to be covered. The good news is that your employer will usually compensate you, and if not, you can write off the expense on your income taxes.

Making Claims

If you frequently file claims with your insurance company, even for accidents that are not your fault, your premiums will go up.  The insurance company sees that you are a higher risk because of where you are driving or the time of day you are driving. 

Citations and Tickets

If you get speeding tickets or reckless driving tickets, your rates will start to go up quickly.  These tickets show that you are a riskier driver.

What Will Lower Your Rates

Insurance companies consider many factors that can help lower your insurance rates, but be warned – if you tell your insurance company you qualify for these discounts but they find out you were misleading them, your policy will be cancelled and you may even be prosecuted for fraud.

Garage Parked Car

If you park your car in a garage each night, you can get a huge reduction in your monthly premiums. This is because cars parked in a garage see less “wear and tear” from the elements like rain and snow, get less damage from vandalism and debris, and are far less likely to get hit by other drivers while parked.

Policy Bundle

If you have renter’s insurance, homeowner’s insurance, or any other type of liability insurance, your insurance provider might offer a bundle price in order to get all of your business. Bundling different types of insurance with one company could knock off 15% from your premium costs for each of your insurance policies.

Fewer Claims

If you do not file claims frequently or if you have never filed a claim, your premiums will start to fall after a few years.  You have shown the insurance company that you are low risk.

Safe Driver Courses

You may be able to take Driver’s Ed or a Safe Driver class and get a few dollars knocked off your insurance premium each month. Being an educated driver means you are less risky because you’ve learned how to be a safer driver.  Many insurance companies will require you to take a safe driver course after receiving a certain number of speeding tickets or citations.  If you do, you can avoid a huge spike in your premium.

Shopping Around

Your monthly premium is determined partially by your history of claims, but you can also save money on this cost by getting a strong understanding of how insurance works. When you sign up for a policy, your insurance company will put you into a pool with dozens or even hundreds of other drivers who have similar characteristics (age, number of claims, type of vehicle, etc.). The insurance company then determines how much to charge you based on the average amount of money it had to pay out in claims for this group in previous years. 

The criteria used to determine which group you should be part of changes from year to year, and it will be different for different insurance companies.  Once you are part of a particular group within one insurance company, you most likely will not be moved to a less expensive group, even if you qualify.  Insurance companies tend to review their “group characteristics” only every few years.  If two insurance companies had completely identical groups, the premium cost could be different for individuals in both groups simply because one insurance company might pay out a more for claims than the other company.  So new customers being added to the “pool” would be charged different premium rates.  Why should you understand this?  You could end up saving hundreds of dollars simply by shopping around at different insurance companies regularly. Even if your rates do not change from year to year with one company, they might be drastically different if you apply 12 months later with a different company.  Most experts recommend shopping for new auto insurance at least once every two years.

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[qsm quiz=115]

Car Insurance

1. In your opinion, should every driver or car on the road be insured?
2. Using examples , state and explain the different types of car insurance that are available.
3. Using examples, explain what a deductible is.
4. Explain what is meant by the term premium when discussing insurance.
5. What is the difference between Tort and No fault?
6. In what ways could your actions cause your insurance premium to increase?
7. In what way are you able to reduce your insurance premium?

Once you file your income taxes, the IRS will review all the forms you submit (your tax return) and either accept your submission or reject and return it to you for a correction, usually with very little turnaround time.  This can happen whether you are paying what you owe or receiving a refund.  However, occasionally the IRS will decide to “audit” your tax return, asking you to provide some supporting documentation before your tax return is accepted. 

The Basics of an Audit

An audit is what happens when the IRS chooses to examine your tax return more closely, verifying that your income and deductions are accurate. The auditing process is designed to catch errors in tax returns, verify that the correct amount of tax is being paid, and preventing fraudulent tax claims. 

Getting Audited

Audits can be triggered by a random selection process or if your tax return information contains anything suspicious. Audits are normally triggered within 3 years of the filing date, but in some cases an audit can occur up to 6 years after filing your initial return. If you file taxes with a professional accountant, that accountant will usually accompany you through the entire auditing process and do almost all of the leg work. If you file on your own, you will need to go through the auditing process on your own as well.

The reason the audit timeline differs is mostly political.  Congress has repeatedly cut the IRS budget over the last few years, resulting in tens of thousands of fewer auditors, with far less training each, so the auditing process takes longer each year, creating a growing backlog. Because of this backlog, you need to keep all financial records used to prepare your tax return for about 7 years beyond the filing date to ensure you are prepared in case of an audit. The shortage in personnel also means fewer audits are conducted due to random selection and more are due to tax returns triggering an audit due to suspicious activity.

What is suspicious about my return?

IRS auditing agents do not review every tax return. Most tax returns are processed automatically, with the data read, processed, and stored by a computer. Since all this data is in one place, the IRS has a research division that carefully combs through all the data to find statistical patterns. They use these statistics to build models of what most returns should look like, based on what the person is claiming. For example, returns filed by married couples with children look more similar than single people filing alone.

When returns are submitted and the information does not fall in line with what would be “expected,” that return gets flagged for an audit, and an IRS expert gives it a closer look.

What do auditors need?

If you get selected for an audit, the auditor will ask to see your financial records in order to verify that the claims you made on your tax return were accurate and justified. You should not need to generate any new records for an audit.  Generally you will only need the same documents you used when completing your tax return.  For example, if your tax return included a $1000 donation to a charitable organization, you will be asked to provide a copy of your donation receipt. 

If you do need to submit any documents to the IRS, each document should include a note of what it is and how it applies to their request and your return. Click here for a list of the records that auditors might request.

Steps of an Audit

There are two basic steps of an audit. When your return is first flagged for an audit, it is reviewed by an experienced auditor and analyzed in detail. This auditor can either accept your return as is or forward your paperwork to an examining group.

If the experienced auditor accepts your return with no changes, your paperwork will be processed normally, and you may not even be aware it was ever flagged at all.  If it is forwarded to an examination group, you will be notified by mail of what exactly the auditors are looking into. You can be audited either in person or by mail.  This is usually determined by the complexity of your return and how many flags were raised by the first auditor.

You will only be notified of an audit by mail.  The IRS will never call you by phone to inform you of an audit or to demand payment. (Note:  This is a very common scam.)

Audits by Mail

Audits by mail are very easy affairs.  The paperwork you receive from the IRS will explain why you are being audited and what they are looking for, and you will be asked to mail specific supporting documentation, usually receipts, logs, or records detailing your expenses. You simply need to mail the IRS copies of those documents and they will review what you provide. (Never mail your original documents since they could be lost in the mail.)

Audits in Person

In-person audits are a more formal affair. You can be asked to come in person to a local IRS office, or an IRS agent may ask to meet with you at your home, place of work, or with your accountant. You will be asked to choose the date and location, which must be arranged with your auditor.

In-person audits are usually requested for more complex audits where several flags were raised with your return, allowing the auditor time to ask specific questions about specific items.

If you are contacted for an in-person audit, the IRS will still specify the reason why you are being audited and ask for specific documents, but it is always a good idea to bring as much documentation as possible to the meeting. Bring copies of your documents since the auditors may need to keep some of your records as they make their decision.  They should not be given originals.

Auditing Results

After mailing your documentation or meeting with the auditors, the auditors reviewing your tax return will confer and discuss your paperwork and the information you have provided. You will always be notified when an audit has concluded and a decision has been reached.

The auditing team will either accept your return with no changes (meaning they were satisfied with the documentation you provided) or will request changes. You can either accept or reject their proposed changes.

If you accept the changes, you will sign a document confirming you understand and agree to the changes. This has the same effect as filing a revised tax return. If the revision means you owe additional taxes, you will need to pay them in full at this time or through installment payments.

If you reject the changes, you can request a conference with a higher-ranked IRS agent  who will review the auditing process and your objections. If you disagree with this agent as well, you can take your case to mediation where a third party discusses the issues with both you and the auditing committee, or you can take your case to Tax Court where you will need a lawyer to argue your cause in front of a judge.

Very few disputes end in Tax Court since most taxpayers and the IRS prefer to resolve the issue through mediation rather than pursuing an expensive legal process. Click Here for more information from the IRS website.

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This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

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[qsm quiz=113]

Challenge Questions

1. What is a tax audit?
2. What is an auditor?
3. How are tax returns audited?
4. In your opinion, should your taxes be audited?

Most young people are perfectly capable filing their own taxes using the IRS Form 1040. However, as your personal finances grow more complex and you become eligible for tax credits, have multiple sources of income, or need to report common tax additions, filing your own taxes becomes more complicated.  At the point where completing your own tax return becomes a burden, you may want to consider hiring a tax professional for help. 

What Choices Are Available When Completing Your Tax Return?

People generally have very mixed attitudes towards hiring a tax professional to assist with fileing their taxes. Some people believe it is a waste of money, choosing instead to work through the tax worksheets by themselves. Others purchase tax preparation software or use online tax preparation services, like TurboTax or TaxSlayer, which simplifies most of the worksheets and forms. Still others prefer meeting with an accountant face-to-face, explaining their tax situation and letting the professional do all the leg work.

You will need to decide which method is best for you by considering your cost and benefits.  Use the following guidelines when making your decision on how to file your taxes for this year.

Filing Yourself

Filing taxes yourself means obtaining and printing the required forms, gathering the necessary income, expense, and taxes paid documents, and following the form instructions to fill in the specific numbers.  You will then calculate your tax, deductions, and credits to determine if you owe additional taxes for the year or will be receiving a refund.  Once the calculations have been made and the form has been signed, you are responsible for mailing the tax form and the required supporting documents to the IRS. In the past, this was the way nearly all Americans filed their taxes each year.

Cost

Filing taxes yourself costs nothing but time and a postage stamp.

When To Use This Method

If you have no dependents, tax credits, or additional income to report, filing your taxes using Form 1040 can take as little as 5 minutes, and if you are receiving a tax refund, you can expect a direct deposit to your bank account soon after. The simpler your tax situation, the more sense it makes to file yourself.

When to use a different method

As your personal finances become more complex (usually after having children, purchasing a house, or having a significant amount of investments), the time needed to file your taxes grows exponentially, as does the margin for error. So your “cost” has increased.  Simple calculation errors can trigger an audit, create delays in the processing of your tax return, or cause you to miss out entirely on tax breaks you might qualify for but didn’t realize.

The IRS holds about $1 billion each year in unclaimed refundable tax credits, simply because people failed to file a tax return or they failed to claim credits they were eligible for (most commonly the Earned Income Tax Credit for low income individuals).

Even if you are confident you can file your taxes yourself every year, it is a good idea to file with a qualified tax professional at least once every few years to ensure you have not missed any new tax credits or deductions you were eligible for. You can even use a tax professional to review previously filed returns to make sure nothing was missed, and then file a 1040X correction form to receive any refunds you may have missed.

Tax Preparation Software

Tax preparation software has gained enormous popularity in recent years. There are dozens of software programs and apps to help you file your taxes on-time, and with good reason.  When using the software, all of the calculations are handled automatically, so there is no margin for error with arithmetic mistakes you might make, and the step-by-step instructions make you aware of everything you can claim.

When to use this method

The strongest benefit of using tax preparation software is the ability to quickly and efficiently identify and apply some of the biggest tax deductions, credits, and additions you may be eligible for. This makes tax preparation software very popular with everyone from part-time workers looking to claim their EITC (earned income tax credit) to families with children looking to claim various common tax credits.

When to use a different method

Tax preparation software is not free for most individuals.  This monetary cost is the most common reason why people with simple returns still prefer to file on their own. Tax preparation software is not necessarily easier.  You can still miss out on deductions or credits that may not be very well explained by the software, and it may be difficult to report certain types of extra income (e.g. if you have tips or cash earnings not reported by your employer on your W-2). Reporting investment income and capital gains from the sale of stock may also be fairly complicated when using some versions of tax preparation software.  So if your financial situation seems to be too complicated for you to understand, you probably want to choose to work with a professional.

Professional Accountant

Filing your taxes through a professional accountant is traditionally the most reliable way to get the highest tax refund.  Professional accountants are trained to know the ins and outs of the tax code. Plus they are generally aware of new tax changes that may take affect from year to year. One reason so many people choose to meet with an accountant in person each year is for the human touch. It is educational to actually sit down with someone and review your finances from the past year who can help identify tax breaks, credits, and any other claims you may need to make.

When to use this method

Generally speaking, the more complex your tax filing, the more you will benefit by using a professional accountant. This is certainly true if you have any income not reported on a W-2 or a 1099 form, such as contract work or side jobs.  An accountant can help you get your entire tax situation organized and filed correctly. There is also a benefit in working with an experienced tax professional who has helped thousands of individuals in the past.

Professional tax firms usually offer assistance in case you are audited.  This can remove a huge amount of stress and hassle knowing you have a professional in your corner.

When to use a different method

This expertise does come at a cost.  Filing your taxes through a professional is typically the most expensive way to file since it requires dedicated one-on-one time with a highly-trained expert. If you believe you have very few tax credits or deductions and your financial situation is fairly simple, it will be cheaper to simply file yourself.

During tax season, you may see large accountancy firms advertising a low cost to help you file your income taxes.  However, this low costs generally applies only to a basic return, and you will be charged more if you have any complexities such as interest income or stock dividends to report.  So before booking your appointment, take the time to ask how you will be charged.  Knowing that cost up front will help you make an informed decision about how to file your income tax paperwork this year.

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This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

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[qsm quiz=112]

Challenge Questions

1. Why do taxes exist?
2. In your opinion, what are the advantages and disadvantages of hiring a tax professional?
3. List 3 tax forms mentioned in this article.
4. The IRS holds about $1 billion each year in unclaimed refundable tax credits. What does this mean?

Everyone loves getting tax breaks, but what can really impact your finances is forgetting about tax additions – extra taxes and fees you owe for income that should be reported when you file your income taxes.  Forgetting to include this income and not paying the taxes owed on this amount will hurt you in the long run.  Taxpayers are charged interest on the outstanding tax balance from the date taxes are due (April 15) until the taxes are paid in full. 

This means if you fail to include all of your tax additions in your annual return and get selected for an audit later, you will be charged interest for the entire period between when your taxes were due and when the error was found.  Understanding the additional taxes you might owe and the tax credits and deductions you may qualify for are both important in keeping your finances healthy.

Why do tax additions exist?

Generally speaking, the government wants to make it as easy as possible for you to pay your taxes, so most people do not have any significant tax additions to report. Their main source of income is their earned wages.  However, many individuals earn extra income beyond their wages, and the taxes owed on this income has not yet been reported to the IRS.  It is your responsibility to include these tax additions when you file your income taxes.

If all of your income for the year is reported by your employer on your W-2 form, you will not have any tax additions. However, if you work as a waiter or waitress and earn more than $20 a month in cash tips, you need to report those tips as income on your tax return.  This will increase your Adjusted Gross Income, and therefore increase your tax burden.

Following is a list of the most common situations that create tax additions.

Tips

Legally you need to report your tips to your employer by the 10^th of each month. If you work for a regular restaurant, this is probably part of the normal flow of business.  At the end of each shift, your employer may ask you to calculate how much in tips you earned and report it before you leave.  If this is the case, when you receive your W-2 form, it will already include the tips that your employer knows about.

However, the problem arises if you received tips that your employer does not know about. If you received other tips, then you will need to report them separately using a Form 4137.

Keep in mind that your life will be much easier if all tips are reported to your employer. If you use a Form 4137, the tip amounts can be harder to track over the course of a full year compared to just a month. If your employer does not already keep track of tips, you can ask that they do.  Give them a Form 4070 (Employees Report of Tips to Employer) before the 10^th of each month, and request that they include that information on your W-2 to make filing taxes simpler.

Rents

If you own property and charge a rental fee, you will need to report all of that fee as income.  Rental income is taxed. Excluding rental income on your income tax paperwork is one of the biggest triggers for an audit, and the result can include huge back taxes if ignored.

Reporting rental income is very easy.   The IRS has tax forms specifically for reporting rental income and expenses.  All you need to do is track those numbers over the course of the year so that you can properly report them.  Click Here for the IRS article on reporting rental income and expenses.

Capital Gains

If you have any investments, you will need to report any capital gains (or losses) you experienced during the year.  A capital gain occurs when you sell an asset at a price higher than you purchased it for.  Capital gains alsoinclude dividend payments you received from stocks you own, so even if you don’t actually make stock trades during the year, you might still owe tax.

Larger capital gains occur when you buy or sell property that was held as an investment. If you sell your house that you’ve owned and lived in for 5 years, you will probably not owe taxes on any capital gains.  But if you “flip” a house by buying it, renovating it, and selling it 2 years later, you will owe capital gains on the profit you earned.

Capital gains are taxed at a lower rate than for other income, but they still need to be reported and paid. Click Here for the IRS FAQ for capital gains taxes.

Consumer Use Taxes

When you make purchases at your local store, part of the price you pay includes a sales tax.  However, if you purchase an item online from another state, it is possible that you did not have to pay any tax at that time.  For this item, you would now be responsible for paying that tax yourself.  Instead of paying a sales tax, you would be paying a use tax.  (Since sales taxes are only collected at the local level, use taxes apply only to your state income tax return, not to your federal return.)

Use taxes come up in cases where you normally would owe a sales tax, but for one reason or another none was paid. The most common example is goods purchased from sellers online and shipped to your location.  While the biggest online retailers, such as Amazon, have integrated sales tax charges into their purchases, many smaller sellers have not. If you purchase goods online and did not pay a sales tax, you will need to report the purchase and the taxes owed on your state tax returns.

The exact process for reporting use taxes varies greatly from state to state. Some states will have a specifically line on the income tax form for listing use taxes owed while others will require a separate form to be filed just for use tax.  Your state’s Department of Revenue can provide information about how use tax is handled in your state and what type of purchases may be exempt.  Check that website for details.  Then remember to check your receipts for purchases made from out-of-state companies to determine whether or not you paid sales tax with the purchase or will need to pay use tax now. 

Many people ignore the use tax because it can be complicated to file for very small amounts. However, if you do get caught dodging use taxes, fines and penalties are steep.  In addition to high interest rate penalties, there are failed filing fees, and potentially even jail time if the amounts are high enough.

Other Income

Other Income is a blanket term for any other income you received during the year that was not reported to the IRS with a W-2 or a 1099 form. This typically includes things like cash prizes and award winnings, gambling earnings, and any money you earn on the side as cash, either through your own business or for something like pet sitting.

All of these “other” forms of income are reported using the standard 1040 form and Schedule 1. The exception is if you are earning extra money from a side job or being paid cash for odd jobs – this requires the Form 1040 Schedule 1.  On line 8 of Schedule 1, the form asks you to report “type and amount” of your “other income.”  So if you received $26 for attending jury duty, you would list that there. 

Late Filing Fees

Late filing fees represent “extra money” you may need to pay when you are filing your income taxes.  If you do not file your taxes by the deadline, usually the middle of April, you can be charged both a failure-to-file penalty and a failure-to-pay penalty (if you owe money to the IRS).   Currently the fee for filing late is 5% of the unpaid taxes for each month or part of the month that your taxes are late.  And the fee for paying late is .5% of your unpaid taxes.  The IRS website says that “You should file your tax return on time each year, even if you’re not able to pay all the taxes you owe by the due date. You can reduce additional interest and penalties by paying as much as you can with your tax return.” 

This should help you see how important it is to file your income tax paperwork on time, even if you owe tax and cannot fully pay it. If you need extra time to file your taxes, for example if you are waiting for some paperwork relating to extra income you need to report, you can also file for a short-term extension.  This will give you an additional 120 days to file with no late fee penalty. Click Here for the IRS article on late fees.

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This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

Learn More

[qsm quiz=111]

Challenge Questions

1. What other items, other than you initial income from your paycheck can be taxed?
2. What is a W-2 or 1099?
3. In your opinion, should people pay taxes? If so, why. If not, why not?
4. Using examples, explain what Capital gains is.

When you file your income taxes, you can “write off” certain expenses, and get extra tax credits based on your living situation. This means that if you had a qualifying expense over the course of the year, you basically get to subtract that expense from the income you report to the IRS, which will increase your tax return (or at least lower how much you owe).

Claiming these credits and deductions can be tricky – many people miss out on them simply by not knowing they exist or how to claim them. Only one type of tax credit can be claimed when using the 1040 EZ, so if you think you can claim any others, you will need to use the form 1040 or 1040A (which is the longest, but has the most potential deductions). Actually calculating how much credit or deduction you can get is detailed in the instructions for the 1040.

Deductions VS Credits

There are two ways to reduce your tax bill – a “Deduction” and a “Tax Credit”.

A “Deduction” means you can subtract this amount from your total taxable income, so it will then lower your taxes owed or increase your refund.

A “Tax Credit” is an amount simply subtracted from the amount of tax you are owed. There are also two types of Tax Credits:

• Refundable – if you already owe zero tax, claiming a refundable tax credit means you will get a tax return for that amount
• Non-Refundable – These can reduce your total tax burden to zero, but if it goes lower you won’t get the excess as an extra tax return.

Basically, when you pay an income tax directly from your paycheck, your W-2 form will show how much tax has already been paid. By claiming only “Deductions” and “Non-refundable tax credits”, the most you could get back on your tax return is that full amount.

If you also can claim “Refundable” tax credits, you could end up getting back a return for more than the total taxes you pay.

The Standard Deduction

To make it easier to file taxes, everyone has the option to choose between “Itemized Deductions” or “Standard Deduction”. If you file an “Itemized Deduction”, you need to provide evidence of each item you’re deducting (like receipts and proof it is eligible), which can be very time consuming for small deductions.

Alternatively, if you don’t think you have very much to deduct, you can just claim the “Standard Deduction”, which is a flat $6,300 per person. If you take the Standard Deduction, you get it without having to provide any evidence of anything. Young people with lower incomes and no dependents generally find that their Standard Deduction is bigger than their itemized deduction, and is much easier to work with.

If you do take the standardized deduction, you can still claim other tax credits, but no other deductions. See the IRS page on the Standard Deduction.

Dependents and Children

The most common tax deductions and credits involve families with dependents or children. In order to qualify as your dependent, a person must:

• Be under 18 (17 or 19, for some tax breaks) years old
• Be related to you
• Have lived with you for more than half of the last year
• Not be claimed by someone else as their dependent

If you are able to claim dependents, you cannot use the form 1040 EZ. Click here to see the IRS page on Dependents.

Earned Income Tax Credit

The Earned Income Tax Credit (EITC) is a national program to help raise low and middle income workers out of poverty, specifically targeting families. It is a refundable tax credit.

While you do not necessarily need to have dependents to claim the EITC, you will get a lot more out of it if you do. If you are claiming it without dependents, you can use the 1040 EZ to claim your EITC.

The EITC works by helping people with low income – this means you need to have worked and earned some income for the previous year. The EITC you might be eligible for is shaped like an n – you get very little if you earned very little, then rises with your income to a certain point before tapering off as your income continues to rise.

This is because the EITC is designed to encourage people to be working and earning a wage. For people with very little income from working, the EITC gives very little because it works under the assumption that they are earning other benefits, such as food stamps and housing assistance. It rises in the middle to help the working poor escape poverty, while tapering off as income continues to rise in order to reduce the benefits received by people who no longer require the assistance.

Your EITC goes up significantly if you claim dependents – in 2016 the most you could get with no children was just over $500, while having two children increased the amount to over $5,500.

Graph created by Timothy Taylor of Conversable Economist

Click Here to see the IRS page for the Earned Income Tax Credit.

Child Tax Credits

There are also tax credits available specifically for children, creatively named the “Federal Child Tax Credit” and the “Additional Child Tax Credit”.

Federal Child Tax Credit

The Federal Child Tax Credit gives a simple tax credit for $1000 per child, up to a certain income threshold (between $55,000 and $110,000, depending on your marital status). If you earn more than this threshold, you will have $50 less tax credit for every $1000 over the threshold (so a married couple earning $120,000 would have a $950 tax credit). This tax credit is non-refundable. Click Here to see the IRS FAQ for the Federal Child Tax Credit.

Additional Child Tax Credit

This tax credit basically works off of the Federal Child Tax credit – it takes whatever part you could not refund, and makes up to $3000 of it refundable (again, with an income threshold). The rules for this tax credit get more complicated if you have 3 or more children, but the effect is basically making the non-refundable part of the Federal Child Tax Credit refundable. Click Here for the IRS FAQ for the Additional Child Tax Credit.

The Child Dependent Care Tax Credit

This tax credit was created to offset the cost of daycare and child care – you can deduct between 20% and 30% of any child care expenses under $6000 per child (no tax breaks on costs over $6000). Unlike the other tax credits, this one only applies to children 13 or younger. Click Here for the IRS FAQ for the Child Dependent Care Tax Credit.

Work-Related

There are also many deductions and credits available to offset any work expenses you might pay for yourself.

Job Moving Expense

While you cannot write off any costs incurred in a job search, if you need to move between cities when you get a job, you can usually write off part of the moving expense. This is a deduction, subtracted from your taxable income. Click Here for more information about deducting moving expenses.

Work Equipment

If you need to purchase a uniform or other work-related equipment for your job, you can also write off these expenses. This is a big deal if you are a contractor or self-employed: you may even be able to write off some of your rent, utilities, and other expenses if you work from home. Click here to learn more about work expense write-offs.

Home Ownership

There are also many tax credits and write-offs if you own your home.

Mortgage Interest

If you have a mortgage, some or all of your interest will be tax-deductible. Not all mortgage interest is tax-deductible – you need to provide evidence that your mortgage was taken out to buy your primary residence, or used for extensive renovations, and only applies to interest paid on loans up to $1 million. If your mortgage does not qualify, you can still write off the interest on the first $100,000 of your loan. Click Here for more information about mortgage interest tax credits.

Energy Credits

There are also many tax credits available to help offset the cost of renovations you do to your house, if those renovations help it become more energy efficient. These credits were put in place to help homeowners upgrade old insulation and windows, reducing the total energy cost of keeping the house warmed in the winter and cooled in the summer. The tax credit is typically for around 10% of the purchase cost, but this can vary year to year. Click Here for more information about energy efficiency tax credits.

Bigger energy credits are available if you add green energy equipment to your house, like solar panels or residential wind turbines. These credits are typically for about 30% of the purchase cost.

Education

There are several major tax credits if you attend college, or get extra work training. These are in place to encourage people to keep building more valuable work skills.

Student Loan Interest

You can write off up to $2500 of interest on your student loans per year. This works as a deduction, so this amount is simply subtracted from your taxable income. Note that if your parents help with your student loan payments, you can still claim what they pay on your taxes. Click Here for more information about the Student Loan Interest deduction.

American Opportunity Tax Credit

The American Opportunity Tax Credit gives credit for the first $2500 in education expenses per year, but you need to be enrolled in an accredited university in the United States, and be pursuing a degree. You can only claim this credit for 4 total years, and you must be enrolled for at least one full session in the year you claim it.

This is a semi-refundable tax credit – if your tax burden is already zero, 40% (or up to $1000) is refundable. Click Here for the IRS page on the American Opportunity Tax Credit.

Lifetime Learning Tax Credit

The Lifetime Learning Tax Credit is very similar to the American Opportunity credit, but with a lower threshold – only up to $2000, and is not refundable.

The upside is that you can claim it as many times as you like, and do not need to be enrolled in a degree program (so it also applies to extra courses and skill-building programs). Both the Lifetime Learning and American Opportunity tax credits have income thresholds – as your income goes up, your tax credit will be reduced. Click Here to learn more about the Lifetime Learning Tax Credit.

Insurance and Investments

There are also many breaks you can get for some insurance and investment costs, designed to help offset these costs for lower income workers.

Advanced Premium Tax Credit

If you purchased health insurance through the healthcare.gov exchange, you can claim some of your premiums as a tax credit. The actual amount you can claim will vary greatly based on your income and premiums, but the credit is also refundable. Click Here for the IRS FAQ for the Advanced Premium Tax Credit.

Saver’s Credit

The “Saver’s Credit” is another word for the Retirement Savings Contribution Credit – the purpose of this credit is to encourage saving in retirement accounts and IRAs. This credit is for up to $2000, and is calculated as a percentage of your contributions (either 50%, 20%, or 10%, depending on your income). Click Here for the IRS information on the Saver’s Credit.

Capital Losses

“Capital Losses” is when you have an investment, whether it is stocks, property, or any other asset, and sell it for less than you paid for it. If your stock portfolio has been taking a beating over the last year, you can write off up to $3000 of losses as a deduction. Click Here for more information about capital loss tax credits.

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What is income tax?

Income tax is the tax you pay on your income, usually directly taken out of your paycheck. Everyone who works in the United States should be paying income tax on their earnings.

Income is more than just wages and salaries too. If you earn rents from rental properties, investment income, interest on your savings account or bonds, or any other revenue stream, you will probably owe some income tax on it.

How are income taxes paid?

For most people, income taxes are straightforward – employers are required to withhold the appropriate income tax amount from your paycheck, which is then paid to the government without any extra steps.

If you are self-employed or work as an independent contractor (like a driver for Uber), it can be a bit more complicated. In this case you are required to report your income and pay any taxes owed at the same time.

Who needs to file an income tax return?

All US citizens and everyone working and living in the United States needs to file an income tax return each year. By extension, all citizens and workers in the US need to report their income, even if that income is earned in another country. US citizens use their Social Security Number to file their taxes.

Even US residents who do not work need to file income taxes if they received some sort of income or compensation over the previous year. This includes things like rental earnings and even unemployment benefits.

Immigrant Workers

Workers who work in the United States without a Social Security Number (both legal immigrants and undocumented workers) are still required to pay income taxes. Since some of these workers may not have Social Security Numbers, they can request an Individual Tax Identification Number (ITIN) from the IRS to use to file their taxes.

ITIN numbers can only be used for tax reporting purposes, and undocumented workers can avoid breaking income tax evasion laws by obtaining a ITIN number and filing their income tax returns.

US Citizens Living Abroad

US Citizens who live and work in other countries are also required to file their US income taxes each year or risk heavy fines. While citizens do need to file their taxes, most citizens living and working outside the US are exempt from actually owing any tax, unless they have exceptionally high incomes.

What do I need to file my income taxes?

In addition to a Social Security Number or Tax Identification Number, there are additional forms needed at the minimum to file your income tax.

Form W2

The W-2 form is a document all hourly and salaried employees will receive from their employer at the end of the year (usually in January, covering the previous year). The W-2 form is a fairly basic form outlining the total wages earned in the previous year, along with how much Social Security and Income Tax was already withheld by the employer and paid. Employees receive their W-2 form already filled out from their employer.

You will usually receive 3 copies of your W-2 form – one for your personal records, one to be submitted with your federal tax return, and one for your state tax return.

You can file your income taxes with just a W-2 form if you received no other income or compensation in the previous year.

Form 1099

Form 1099 is used when a person needs to self-report income. This includes independent contractors, and anyone receiving income from a source that did not provide a W-2.

Form 1099 is more complicated than the W-2, both because there are many more types of income that can be reported, and because anyone who uses it may need to fill out all the information themselves (although whoever pays you might provide you with a pre-filled version). This requires more skills at keeping detailed financial records than the basic W-2.

The 1040 Income Tax Return Form

The basic income tax return form in the United States is known as the Form 1040. The basic use of the form is to add up all your income from the year from all sources, calculate how much tax you have already paid, subtract any deductions you qualify for, and see how much of a tax return you should receive or how much tax you currently owe.

The 1040 is a simple one-page tax return. If you have a fairly simple financial situation (few deductions, little external income), you can just fill out the one-page form and send it in. If you have more complicated income and expenses to file, you might need to include additional “Schedules” – supplementary forms outlining your other income and expenses.

Parts of the 1040

There are four basic parts of the 1040

• Contact Information – This will include your name, address, and Social Security Number. You can file the 1040 EZ form jointly with your spouse if you are married, in which case you would provide his or her information as well.
• Income – This information should come directly off of your W-2 form any any interest tax forms your bank sends you for savings accounts. This also includes any unemployment compensation you may have received.
• Payments – This also comes from your W-2, which lists how much tax was already withheld and paid by your employer. This is also where you can calculate the total amount of tax owed.
• Refund or Tax Owed – The final calculations show how much refund you should receive, or how much income tax you need to pay. If you should be getting a refund, you can provide your bank routing number for a direct deposit. If you owe tax, there are instructions included on how to pay it.

Collecting your return

It is easy to collect your return. All income tax return forms include a place where you can put your bank routing information to get your return direct deposited to your bank account with no extra steps.

If you prefer receiving a check, the IRS will mail a check to the address you posted at the top of the form.

Income Tax Corrections

Taxpayers have 7 years in the United States to file any corrections. Usually this would be to claim deductions you may have missed, or report income later to avoid tax evasion penalties.

To file an amended tax return, use the Form 1040-X, which is designed specifically for later corrections on a previous return.

IRS Corrections

The IRS may also apply corrections directly based on their own calculations of your taxes owed. If this is the case, they will generally mail you a letter explaining how their calculation differs from theirs, along with a method to dispute their calculation.

The IRS has been known to adjust returns both up and down – they are mainly checking for errors in the deduction amounts and arithmetic to ensure the returns are processed correctly.

Audits

There is a small chance that your income tax could be audited by the IRS, in which case they will ask you to bring in supporting documents. Audits are designed both to ensure the tax returns are using all the correct values, and to prevent fraudulent claims. Audits can happen up to 6 years after your taxes have been filed, so you should be sure to keep all your supporting documents for at least that long.

State income taxes

Most states also levy an income tax, but the actual tax amount and thresholds will vary quite a lot from state to state. Steps for filing state income taxes are very similar to the federal taxes, and generally require the same documentation (which is why you will typically receive 3 copies of a W-2 form).

There are currently seven states with no income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. States that do not charge income tax make up for the lost revenue through other channels, usually sales taxes and use taxes (in fact, states with no income tax typically charge their citizens higher total taxes than those who do have income taxes).

Pop Quiz

[qsm quiz=106]

What Is Sales Tax?

“Sales Tax” is a tax that is charged on goods sold to end customers, the final user of that product.  The sales tax is a set percentage of the sale price of the goods sold, and individual states set their own sales tax percentages.  Most states use sales taxes to generate revenue to pay for the state’s operations, but some charge no sales tax at all. These are Alaska, Delaware, Montana, New Hampshire, and Oregon. Many cities also impose a sales tax, so the actual amount of sales tax you pay for a purchase will vary quite a bit if you travel.

Who Collects Sales Taxes?

Sales taxes are collected by businesses at the time they sell goods or services. Most states require the businesses to remit the amount collected either monthly, quarterly, or yearly.  Different levels of government (city, state, and national) have different rules for when sales taxes need to be remitted back to the government.  If you are a new business owner, your state’s revenue office sets the time frame based on how long the company has been in business and how much tax they expect to collect throughout the year.  Sales taxes are required on all cash transactions, credit sales, installment sales, lay-away sales, and sales involving trade-ins or exchange of property.  (For those of you thinking you might want to own your own company one day, accounting for and paying sales taxes can be one of the most confusing parts of starting a retail business.)

As a consumer, you may notice that sales tax is almost always added to your receipt as a separate line item, but businesses are not required to charge sales tax separately. In theory, businesses could simply pay the government out-of-pocket for the tax they owe on the products they’ve sold, but it is much easier for them to determine the amount they owe if they charge and account for product sales and taxes separately.

Sales Tax Vs Use Tax

Sometimes when a product is sold, the buyer is responsible for paying the taxes.  This tax is called a Use Tax.  Use taxes are generally applied to transactions where no sales tax was charged at the point of sale. Think about this example.  Let’s say you live in Oregon where there is no sales tax and you purchase a $1000 desk from a manufacturer in Kalama, Washington.  You would pay the price for the desk and would be responsible for paying the use tax of 6.5% tax for the state of Washington and 1.4% tax for the city of Kalama.  It is your responsibility to self-assess and report your use tax liability to your state Department of Revenue. 

What Purchases Are Exempt From Sales Tax?

Even in states and cities with sales taxes, not every purchase is subject to a sales tax.

Groceries

Most states have certain tax exemptions for groceries, usually taxing groceries at a lower rate or assessing no tax at all. While most groceries do get a tax break, “junk food” (with high fat and/or sugar content) and “prepared foods” (such as roasted chicken that is ready to eat) are still taxed at the full rate.

Out-Of-State

Sales taxes only need to be paid for residents of that state, so if you are purchasing a good or service from a different state, you may be exempt from that state’s sales tax. You also see this if you travel internationally.  Airports that have international flights often have “duty free” shops.  These are stores whose goods are exempt from paying national taxes based on the requirement that the goods are sold to travelers who are taking them out of the country.  (Remember that if your purchase is exempt from paying sales tax, you may still be required to pay a Use Tax in your home state.)

In every day practice, you likely would be required to fill out a “sales tax return” with that state’s government.

Non-Profit

Goods and services sold to not-for-profit organizations are generally sales tax-exempt. The organization has to be registered as a Not-for-Profit organization, and it has to request an Exemption Certificate from whichever government would normally be collecting that tax.

Goods for Resale

If you purchase goods and intend to re-sell them, you are also tax-exempt on that purchase. This comes into play most often with small businesses who buy merchandise from wholesalers. Like non-profit organizations, resellers are also required to obtain an Exemption Certificate for their purchases.

Sales Tax Holidays

Some states have “sales tax holidays” where sales taxes are suspended either entirely, or for certain classes of goods. For example, Texas has a sales tax holiday in August each year for clothing, footwear, school supplies, and backpacks (that cost less than $100).  The intention is to help families purchase needed supplies as they prepare to send their children back to school.

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[qsm quiz=104]

Challenge Questions

1. What is the sales tax percentage in your state?
2. Explain how you would calculate sales tax using your own example.
3. List 10 states and their sale tax rates.
4. Why might sales tax vary from state to state?
5. When your sales tax is collected by the local governing bodies, how is it used?
6. Who is the Governor of your state and how has taxes been used in your area?

Short-term financing means taking out a loan to make a purchase, usually with a loan term of less than one year. There are many different types of short-term financing, the most common of which are “Buy Now, Pay Later,” “Unsecured Personal Loans,” and “Payday Loans.”

Short-Term Financing vs Credit Cards

Short-term financing has terms similar to credit cards.  It usually includes a grace period, a set interest rate, and monthly minimum payments.

The biggest difference is that credit cards operate on revolving credit.  This means as you pay down your outstanding balance, you can continue using your credit card. In fact, your credit card company loves when you keep an outstanding balance because you will continually pay them interest.  This is how credit card companies make their money.

In contrast, short-term financing is usually used for one specific purchase or for one single sum of money which is then expected to be paid off over a fairly short period of time. As a borrower, you probably would not be using the same source of short-term financing more than once or twice.  If you do, this should be a red flag for how you are managing your finances.

Types of Short Term Financing

There are three major types of short-term financing – Buy Now, Pay Later, Unsecured Personal Loans, and Payday Loans.

Buy Now, Pay Later

Many stores offer Buy Now, Pay Later loans, both in person and online. With this type of financing, you can typically walk out of the store with your purchase immediately, then pay for it later either through installments or through monthly payments that begin after a set period of time. These loans can be attractive if you are low on cash since they allow for instant gratification.

How do they work?

Like credit cards, many of these loans include a “grace period” that allows you to pay the balance in full before any interest is charged.  This is typically a main selling point for companies since “No payments for 3 months!” sounds great to consumers.

At the end of the grace period, you will be charged interest for the full grace period, and you will be required to make minimum monthly payments until the loan is paid in full.  The main difference between this type of financing and using a credit card is that the grace period is typically longer, sometimes three to six months, and you will be expected to pay off the full amount of the loan after a set period of time.  You are not able to maintain a “revolving balance” like you can with a credit card.  Note:  Some companies waive the interest charge in the grace period as well advertising something like “No payments and no interest for 30 days.”

Should I use these loans?

If a seller is offering you this type of financing, they generally are making money on selling the item you are buying, not from the interest on the loan itself.  For them, it is okay if you pay off the full amount within the grace period because then they don’t have to worry about collecting monthly payments from you. However, they also know that the longer it takes you to pay, the more interest they are receiving from the payment of your loan. 

If you don’t pay off the loan during the grace period, your interest charges will add up faster than if you made the same purchase with a credit card. This is because with a credit card, you have a shorter grace period, so you begin paying down the loan faster. With a longer grace period, interest is able to build up on the full loan amount for a longer period of time, so you end up paying more in the long run.

Buy Now, Pay Later loans are usually advertised to buyers who have low or bad credit and who may not have any other means of financing available. The bottom line is that if you are choosing between buying something with your credit card or using “Buy Now, Pay Later,” you will probably be better off using your credit card.

Unsecured Personal Loans

Unsecured Personal Loans refer to any loan you take out without providing collateral. In fact, credit cards are one type of unsecured personal loans. You can also go to your bank or another financial institution for a one-time unsecured personal loan.  This works similarly to taking a cash advance from your credit card.

How do they work?

Receiving an unsecured personal loan is fairly straightforward.  You go to your bank or any other lender and ask for a short-term line of credit. You will typically be approved for a set credit line, say $5,000, based on your credit history and income.

This type of short-term financing is most common for emergencies and unplanned expenses, such as car repairs or medical bills. These types of loans typically have a shorter grace period, about the same or less than a credit card. The interest rate varies, but is typically about the same or higher than for a credit card.

Should I use these loans?

Taking a short-term unsecured loan is usually not an easy choice to make because you will most likely be faced with them during times of emergency for expenses higher than your credit card limit allows. If you can, you will usually be better off putting these purchases on your credit card, which may have a longer grace period at a lower interest rate.

If the amount you need to borrow is higher than your credit card’s credit limit, try first to borrow money from friends and family or to get an unsecured loan from a commercial bank, credit union, or savings & loan.  If you are tempted to work with an alternative creditor, beware.  The more the creditor advertises that they work with people with low or bad credit, the worse deal you will probably get.

Payday Loans

Payday loans are the riskiest type of loan you can take. These loans are typically offered as a “bridge” between an expense (such as rent) and your next paycheck, usually with term lengths of less than 1 month. These loans can be either unsecured or secured.  Secured payday loans typically require a car title as collateral. This means that if you fail to pay back the payday loan, your car could be seized and auctioned off to pay for your debt.

These loans include extremely high interest rates (often over 1000% APR) and little to no grace period. In theory, you could pay a very small finance charge if you take out the loan and immediately repay it within the next week or two, but over 80% of payday loans get “rolled over” into the next period.  Rolling over a payday loan is what happens if you cannot repay the full amount on or before the due date, usually within 2 weeks (when you’d receive your next paycheck). Payday loan offices make most of their money on these rollover finance charges which are typically $15 to $20 for every $100 borrowed.

Here’s how you could be trapped in a payday loan cycle.  If you take out a $500 payday loan with a 2-week repayment date and a $50 finance charge, you would need to pay $550 in 2 weeks. If you cannot pay the $550 and have to roll over the loan for another 2 weeks, you would be charged the interest again, another $50.  So now you owe $600.  This loan went from a 10% interest rate to a 20% interest rate in one month, and the interest owed piles up fast.

Should I use these loans?

NO! From a personal finance perspective, it is never a good idea to use payday loans. If you think you need a loan in order to make your rent or utilities payment, just talk with your landlord or utility company.  They will almost certainly charge you less in late fees than you would pay in interest on a payday loan.

Payday loan offices appear most often in communities with a shortage of commercial banks, credit unions, and savings & loan institutions. This means that those communities are often cut off from unsecured loan options, leaving payday loan offices as the only source of short-term credit for emergencies.

If you ever find yourself in a situation where a payday loan seems to be your only option, remember this: From a personal finance perspective, you are almost certainly better off missing the payment entirely than taking a payday loan.

Try It

Try matching the characteristics to each loan type:

Short Term Financing – The Bottom Line

At the end of the day, if you need short-term financing, your best bet will probably be your credit card instead of any of these methods. If you do have an urgent expense that your credit card cannot cover, see if your bank can help or talk to friends and family. If you want to keep your personal finances healthy, avoid Buy Now, Pay Later schemes and Payday Loans entirely.

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Learn More

[qsm quiz=98]

Challenge Questions

1. In your own words, explain with examples what short term financing is.
2. How are credit cards and payday loan similar?
3. How can missing a payment on your credit card or loan be a problem for you?
4. How might buying something when you can outright afford it without the need for credit help you with your finances?

Before Debit Cards

Before the 21^st century, if you wanted to buy groceries or visit the mall, you had 4 options that you could use to pay, all of which had their own drawbacks: Cash, checks, credit cards, and short-term financing.

Cash is always reliable to make a purchase, but is prone to being lost or stolen. Not all shops accept checks, both because they are inconvenient to cash, and because of the ease of check fraud (writing a check for which you do not actually have the bank deposits to pay). Credit and short-term financing both include financing charges, so using these methods usually made purchases more expensive.

Between cash and checks, most people carried an ATM card, which could be used at ATM machines to withdraw cash and check bank balances on the go. Since most people already had these cards, many convenience stores installed ATM machines right near their cash registers, so customers could withdraw cash directly ahead of making a purchase. This meant many stores could eliminate the need to accept checks or credit cards (which also include transaction fees to the businesses for each purchase), and just have all customers use cash, without requiring them to carry it all day.

The Birth of Debit

This system began in the 1970’s, when the first ATM machines were invented, and still continues today in some older convenience stores that have not adopted their own card readers. However, in the 1980’s and 1990’s, some bigger grocery stores and other chains began integrating the ATM system directly in to their checkout system. This allowed “ATM” purchases – allowing customers to make payments directly from their bank account, without relying on paper checks. This system is called “online debit”, since every time you make a payment, the debit card reader validates the purchase immediately against your bank balance and executes the transaction.

This system was popular (and is still in place today), but there was one piece missing – stores around the world already accepted credit cards, and the process of integrating ATMs with the checkout system was costly. To get around this last hurdle, banks that issued ATM cards began working directly with credit card issuers to build the modern Debit Card – an ATM card that can also process payments anywhere credit cards are accepted. This type of payment, called “offline debit”, works differently – instead of validating the transaction immediately, transactions are validated in batches by the credit card companies (usually within 1-2 days).

Online and Offline Debit

Online debit works almost instantly – if you have a mobile app for your checking account, you will probably see the funds get deducted from your account a few minutes after a purchase has completed. Offline debit does not work quite as fast. Instead of immediately deducting the funds, the credit card processor usually puts a “hold” on your account for the purchase amount, then actually deducts the payment a few days later.

Because of this delay, you should still always keep a record of all your debit purchases – otherwise you could accidentally overdraw based on just a quick check of your bank balance.

Sometimes you will have the option to pick which transaction you want – if a card reader asks “Debit or Credit” for your card, the “Debit” transaction is typically online, while the “Credit” option is typically offline.

Debit Limits and Fees

Debit cards work similarly to credit cards when you want to buy something, but the fees work very differently. Credit cards make their money by charging interest on borrowed amounts, they usually do not charge customers for each transaction (or limit the number of transactions you can make).

Debit cards use your already existing bank balances, so you won’t get interest charges, but banks do still charge to use them.

Typical debit cards issued to young people might have a few different kinds of charges:

• Account Fees – this would be a fee charged for having your checking account. This fee will usually go up or down depending on your checking account type – account types that give you more flexibility with your debit card are usually more expensive
• Usage Limits – your bank may limit the number of times you can use your debit card per month (which can be as low as 10 transactions). If you go over this limit, you will typically be charged a fee per transaction.
• Overdraft fees – Overdraft fees happen when you spend more on your debit card than you had in your checking account. Your checking account may or may not allow overdraft – you can choose to opt in or opt out. If your account does not allow overdraft and you attempt to make an “online debit” transaction, the transaction will be declined.

Pop Quiz

[qsm quiz=86]

Challenge Questions

1. How is a debit card and credit card different?
2. How might using a credit card at an ATM be different than using a Debit card?
3. How do you know if some ATM machines charge for their services.
4. List 5 places where an ATM is located near to where you live.

Beginners trying to tackle their personal finances for the first time see debt as sort of a “boogeyman,” a specter that looms overhead, trying to trap people into inescapable cycles of minimum payments and late fees. Or at the very least, something to be avoided whenever possible.

Deep down, we all know this is not really the case. Having a healthy amount of debt is almost an essential part of growth but taking on lots of small debts frequently can also be very dangerous to your bottom line.

Distinguishing Good Debt from Bad Debt

When we talk about “good debt”, it usually refers to debt that was taken on to help advance your future income or increase your net worth. Bad debt, on the other hand, is debt that is taken on with no real long-term gain.

Examples of Good Debt

Good debt can include things like

1. Student loans to get a new degree or certification that improves your job prospects
2. A mortgage on a house
3. Refinancing a loan on your house for home improvements
4. A car loan
5. Short-term credit card debt

In all of these cases, the debt is taken on to serve some specific purpose. A student loan to pay for education is a long-term investment in making yourself a higher income earner. Taking out a mortgage to buy a house can greatly increase your net worth in the long run, and mortgage payments can frequently be lower than rental payments.  Refinancing your home means taking out a loan based on the equity you have built up through past payments.  This can allow you to reduce your interest rates or to finance home improvements that can make your home more valuable before selling it. Car loans can greatly increase your job prospects by providing a flexible transportation option.  Short-term credit card debt can be beneficial to your current financial situation, depending on your bank fees and credit card perks.

When Good Debt Goes Bad

All of the examples above are examples of debt taken on for exactly the right reasons.  But this debt can still turn bad, becoming burdensome to your personal financial situation.

1. You may drop out of school or not finish your degree, but you are still responsible for repaying your student loan
2. The interest you pay on your home mortgage may be greater than the property’s increase in value over the course of the loan
3. You may refinance your home loan at a less favorable interest rate
4. You may take out a car loan and end up with a car in constant need of repairs
5. A crisis may hit, causing you to make purchases that increase your credit card balances

All of these transformations can happen with little notice, but good financial planning helps you identify the risk before you take on debt and helps you plan for when things go wrong.

Identifying Risk

Identifying risk before taking on debt is an exercise in financial planning – looking at what you are expecting and determining the chances that something might go wrong. Other lessons in this course will provide more details on how to identify certain types of risk, but here are some of the factors to look for in the debt we have covered in this lesson.

Student Loans

Before choosing what to study or your specific career path, make a list of your top 5 areas of interest.  Then research jobs in each of those fields.  Look for answers to questions such as “How much does each job pay?” and “How much competition will there be in this job field when I am ready to apply?”.  This simple exercise can help you visualize not just what you need to do to succeed in each of these desired paths, but it will also help you determine how likely taking on this debt is going to pay off.

Home Mortgages

Before you decided to buy a home, there are many questions you need to answer.  How long do you plan on living in this home?  Five years or 30 years?  How have property values changed in this area over time?  How do property values in this location line up with the property market as a whole? If you lose your job, how long can you keep paying the mortgage? Remember that when you are renting, it is much easier to move somewhere cheaper than it will be to try to sell your home.

Refinancing A Loan

Before you refinance a home loan, carefully consider how much you need that loan. Refinancing for a better interest rate is usually a smart move, but investing in home improvements can be trickier. Will those home improvements increase the value of your home when it’s time to sell?  It is not a good idea to refinance a mortgage just to deposit the cash in your bank account, but if you have other debts that need to be paid, the cash acquired through refinancing can help. 

Keeping Your Debt Good

How can you keep your debt from turning bad?

The key is being able to look realistically at your potential purchase and try to remove emotions from the decision. Is this debt something that will really help your position in the long run? If yes, take time to make an itemized list of the potential risks so you are thinking ahead.

Next, evaluate how taking on this debt will impact your budget or your spending plan. Long-term debt is considered a “fixed need” while short-term credit card debt is a “variable need.”

If all of this sounds like a lot of work before making a purchase, you’re right. It is! Taking on debt is something to always carefully consider.  Debt will make a significant dent in your ability to meet your other financial goals.

If you are in control of your personal finances, you will likely have good debt taking up a sizable piece of your monthly spending. As long as you can afford this debt, making on-time payments regularly, you will feel good about the progress you are making in improving your self-worth.  But if things start to get out of control in your life, you might find your good debts turning bad.  If this happens, find a way to resolve them as quickly as possible.

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Challenge Questions

1. In your own words, explain the difference between good debt and bad debt.
2. How might good debt become bad debt?
3. How can emotions cause you to increase your debt?
4. When refinancing homes, what risks should people be aware of?
5. Are there ways in which people can take to minimize their debt?

Automatic Payments – Blessing Or Curse?

That title may be a bit hyperbolic – Automatic Bill Payments can be a huge time saver, and do help make sure your bills get paid on time (avoiding late fees and general headaches). This does come at a price, though – when your bills are automatically paid, you may not always have a receipt on hand, or realize exactly when the payment processes.

This can wreak havoc on your planning processes and account reconciliations, and can be especially dangerous if you generally rely on your online bank balance to decide whether or not you have enough cash for a particular purchase.

If you have automatic bill payments set up for your rent, cell phone bill, credit card, and internet access, it is very important to know exactly when each of these bills is paid to get an accurate measure of how much surplus you have left in the month. This might be obvious for a rent bill that accounts for 20% of your monthly spending, but much less obvious for smaller cell phone bills or automatic savings withdraws.

The most common problems people have with automatic payments is when one processes late, or forgetting about one of them and making a purchase that sets you over your spending limits. If you already have a savings cushion, this might not be a problem, but bigger purchases can end up with your payments overdrawn or bounced checks. This can rack up banking fees very quickly, making the problem even worse than it was to start with.

Automatic Payments and the Importance of Budgeting

This is where your budget comes in. If you take time to update your budget regularly, you should have a very good idea of what your expected surplus is at the end of the month after all your automatic bill payments are processed.

This means that instead of relying on checking your bank balance before making a purchase or going out, you can just think about how your current spending decision fits into the budget or spending plan you already have laid out. If you know how much surplus you expected, and approximately how much your current spending has lined up with your plan, it makes it much easier to decide if a potential purchase fits into your plan or not.

Account Reconciliation

The rise of automatic payments means that the exercise of reconciling your accounts, or evaluating how much you’ve spent versus how much you expected to spend, takes on much greater importance. Click here to read more about account reconciliation!

The “Best Practice” is to do your account reconciliation and updating your budget/spending plan once per month, at the same time. This means that you can directly evaluate your spending habits and your financial goals, but to do this you absolutely must have an accurate picture of your account balances and spending when you sit down to do it.

This means that any expected automatic payments that have not yet executed need to be taken into account. With the rest of your account reconciliation, you are just comparing your receipts of purchases already made to what your bank transaction history tells you. If you use automatic payments, you need to add an extra step in confirming that each of your expected automatic payments from each month has also been processed. If not, you can make the adjustment yourself in your spreadsheet, but letting it go forgotten can seriously hurt your ability to make solid plans for the future.

Pop Quiz

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Challenge Questions

1. What are the advantages and disadvantages of setting up auto payments?
2. How might creating a monthly calendar of when payments go out help you with your budgeting?
3. How can cash flow be a factor when setting up auto payments?
4. How might having an emergency fund be a good thing when setting up an auto payment?

When learning about managing your finances, many experts will recommend you begin with a budget.  A budget is a tool that tracks income and expenses, and it allow you to set goals and make plans for the future.  Developing a budget for a specific project, for a special event, or to help you with your monthly spending are all examples of using a budget to help you manage your financial situation.

Your Personal Budget

When you mention the word “budget” to others, you may get a negative response. That’s because people often associate budgeting with restrictions.  They feel that if they go on a budget, it’s like going on a diet.  They won’t be able to spend money in the way that they’d like. But a budget is really a financial planning tool. Every person or household should have a personal budget, not just to help keep spending under control, but also to help achieve what’s important financially, whether that’s saving for college, buying a second car, or going on that Hawaiian vacation. An effective budget will give you a clear picture of your expected income, a detailed look at where you spend your money, and it will help you set and achieve realistic savings goals.

There’s a reason that the word “personal” is used with budgeting.  Although guidelines are often provided to help you determine how much to spend in different areas of your life, the choice is really yours.  Your budget is designed for you based on your goals, so if you have enough income to spend more on your transportation needs, then go ahead and buy that Tesla.  The purpose of having a budget is so that you have a plan for spending your money. This helps you avoid debt and achieve what you want to with your money.

In order to build your personal budget, you will need to gather your financial records, spend time to categorize and analyze your current spending, create a balance between earnings and expenses, consciously plan for expenses that you might be facing in the future, and put everything together while considering your long-term financial goals.

Gathering Your Financial Records

Your financial records include items like receipts from your last few months of spending, credit card and bank statements, your recent pay stubs, and your rent and cell phone contracts. When you are building your budget for the first time, gather as much information as you can on your past spending, if possible for the past few months.

Your goal when gathering your financial records is to have a completely clear picture of how you already spend your money. The biggest challenge of building a good budget is making sure it is realistic. Having exact records of how you spent your money is the best way to plan moving forward.

Categorizing and Analyzing Your Spending

Once you have your records in front of you, it’s time to categorize your spending.  Your goal is to separate all of your spending into needs versus wants, and then into fixed versus variable expenses.

Needs and Wants

Needs are the things you must purchase in order to survive. They include necessities such as rent, utility bills, groceries, and medical expenses.  They also include legal responsibilities such as paying taxes.

Wants are things that you chose to spend money on, but in theory they are items you don’t really need.  Eating out, holiday gifts for friends and family, TV/streaming subscriptions, and new clothes might be in this category.

Once you have sorted your records into needs versus wants, you need to look closer and divide them into “fixed” and “variable” expenses.

Fixed and Variable

Fixed expenses are items whose cost stays the same from one month to the next.  This means you can reliably plan for these expenditures. They include expenses such as rent, your cell phone bill, or a subscription fee for a video streaming service.

Variable expenses change from month to month, so it is hard to plan accurately for these expenses. They might include how much you spend on fashion, how many times you go out to eat, or how much you spend on gas for your car.

Some of your expenses may need to be split into smaller categories.  For example, food is a need, so you could try to lump all of the money you’ve spent on “eating” into one category.  But it’s more honest and will help you create a realistic plan if you separate your food items into categories such as groceries, coffee, and eating out.

Putting It All Together

Once you have finished sorting your records, list the categories of everything you’ve spent money on, placing the information in 4 different boxes – “Fixed Needs,” “Fixed Wants,” “Variable Needs,” and “Variable Wants.” Every penny you spent in the months you are analyzing should be included in these boxes.

Try to complete this spending analysis for the past six months if you can.  What you’re looking for is enough data so that you can determine your “average spending” in each category. The more months you can look at, the better your future budget plan will be!

Balance Against What You Earn

Once you have taken an honest look on how you spend your money, you can start to balance these numbers against how much you earn.

If you earn all your money from one single full-time job, this part is easy – just look at your most recent pay stubs. But if you have a part-time job or some side hustles, estimating your income each month gets a bit harder.

Remember that the more months you can look at, the more accurate the numbers will be for your future budget. When reviewing your income numbers, take an average of what you have been earning.  Do not assume you will always make as much as you did last month or in your “best” month. Be honest with yourself. It is better to have extra income at the end of the month than to always be expecting more income than you actually received.

Once you’ve determined this average income number, you can compare it with your normal spending.  If the result shows that you are already earning more than you are spending, great!  If your income is less than your spending, you will know you have some work to do.  But regardless of what you see, there is still more planning to do.

Looking Ahead

Budgeting helps you make a definite plan to save money for those things you want and need in the future.  There are several strategies to help you plan for unexpected and irregular expenses, but most come down to spending a few minutes for planning. One simple task will help you look ahead at expected expenses that often sneak up on you because you don’t pay them regularly.  The task involves making a chart of irregular expense, determining when they need to be paid, and identifying how much the expenses will most likely be.  (Use the previous year’s numbers to help you estimate this year’s costs.)  Think about what holidays are coming up, and how much you plan on spending on gifts. If you visit the dentist twice a year, include that in your chart so you have the extra cash set aside BEFORE the visit.

Here’s an example of what this budget planning chart might look like.

Remember that being honest with yourself and including as much information as possible will make your budget a valuable document to help you with financial decisions.  Pretending expenses are smaller than they really are or forgetting to include them in your plan is the fastest way to break your budget. But effectively “planning ahead” for your variable expenses is one of the cornerstones of success.

Setting Your Savings Goal

Now that you have an honest look at how much money flows in and how much flows out, you can set a realistic savings goal for every month.

Your savings goal will come from two concepts – Pay Yourself First and creating your Emergency Fund.

Pay Yourself First

Pay Yourself First means that you are making your savings goals your #1 priority.  This strategy has consistently proven to be the most effective way to achieve your long-term goals. A pay-yourself-first strategy means that before you pay any bills or address any of your expenses, you set aside money for your savings. You no longer wait to see how much money is left at the end of the month to put into your savings account.  Savings is absolutely “taken care of”.

Following the pay-yourself-first strategy means you would rather hit your savings goals and occasionally be late paying other expenses than wait until the end of the month and only save what is “left over.” Your savings goal sits at the very top of your “Fixed Needs” category every month, and money always goes into savings.

How much should you save?  A good savings goal should be at least 10% of your expected income every month. If you have never been consistent with saving, you may need to immediately find ways to adjust your other expenses so that you can always hit your savings target.

What you do with the money you have saved is up to you.  Investing can help your savings grow, but investing includes risks.  Keeping your money in a savings account is safe, but it is not the fastest way to build wealth.

Your Emergency Fund

An Emergency Fund is savings you have set aside in case of true emergencies — large, unexpected expenses that may completely break your budget. If you are just starting to build an emergency fund, your first goal should be to save enough money to cover one month’s worth of expenses.  Try to reach that goal by the end of a year. Your long-term goal is to save enough money to cover six months’ worth of expenses.  Do this as quickly as possible but target to reach this goal within the next 5 years.

Your emergency fund is not part of your regular savings.  It is money allocated for those unexpected expenses like a major car repair, traveling home for Grandma’s funeral, or physical therapy following your broken ankle.  If you currently have no emergency fund or your emergency fund contains less money than needed to cover one month’s worth of expenses, cut back on spending in your “Variable Wants” category.  The sacrifice now will help you relax later when you need that money and it is available for you.  If you’ve had to use money from your emergency fund to cover unexpected expenses, you will need to cut back on spending in the following months in order to replenish your fund.

Unlike your regular savings, money in your emergency fund should not be invested. It should be set aside in a savings account, available for immediate withdraw in case of emergencies.

Basic Budgeting Strategies

We have a whole other lesson focusing just on budgeting strategies, but when you build your first budget keep these tips in mind:

• Be honest with yourself. If you are not honest with how much income you have or how you are spending money now, you will never be able to effectively control your spending in the future.
• If you need to make budget cuts, focus on your fixed expenses first. If you can shave money off your rent or downgrade recurring monthly subscriptions, it will have a much bigger long-term impact on your savings goals than if you skip going to the restaurant once or twice a month.
• Set up automatic transfers to move money from your checking account to your savings account either every time you make a deposit or at a fixed time each month. If you do not need to “remember” to set aside money for savings, it makes it much easier to hit your savings goals.
• Spend a few minutes each month doing a “budget status check.” Simply checking your bank account balance might not be enough.  Taking a quick look at your bank account balance, credit card balance, and thinking about bills that still need to be paid that month will give you a good feel for how much money you can safely spend without breaking your budget.
• When you spend less money than you budgeted for, you have freed up money that can be saved or invested. This is a win-win for you. 
• If you go over budget by spending more than you had planned for, it means you will potentially have less money the following month.  You may need to make sacrifices and do with less. Thinking about opportunity cost and doing some comparison shopping will be more important as you now have less money than was anticipated.

[qsm quiz=82]

Challenge Questions

1. What do you understand by the term budget?
2. How might a budget help you with your financial goals?
3. How can you relate opportunity cost to budgets?
4. How would comparison shopping help with your budget?
5. If you pay yourself first, are you more likely to make smarter money decisions with the money that is left and why?

Your parents probably have experience reconciling their checkbook by comparing your own written records with their bank statements.

In today’s world, reconciling your checkbook isn’t a common activity for two reasons:

1. Paper checks probably only account for a small amount of your total expenses per month
2. You probably have an automatic record with your bank’s online services showing how much you paid for anything purchased with a debit card

This does not mean you can skip the account reconciliation though. In fact, the way instant payments and other conveniences work probably make it more important than ever to spend a few minutes per month reconciling your accounts.

What does it mean to reconcile?

In relationships, reconcile means to resolve differences in order to restore friendly relations between two people.  You see this in movies when a married couple gets separated and then decides they still want to be married, or when a daughter decides, after being upset with her father for 20 years, that she wants to reconcile their relationship.  In relationships, reconciling means to make things right.

In financial terms, reconcile means to compare your personal records with the bank’s records to see if they match.  And if they don’t match, you want to discover where the error is and “make it right.”  You don’t want to think that you have more money than you do, and you also don’t want to think that you have less money than you do. So the process of reconciling your bank accounts is important.

Reconciling for the 21^st Century – Why is it Important?

Today you will still get paper receipts for almost every payment you make in person, and online copies of receipts for every purchase you make online.

There are still two factors that make reconciliation necessary:

Entry Errors at Storefronts

The cheapest and easiest way for stores and restaurants to take credit and debit cards is by using a stand-alone card reader. These readers operate independently from the normal cash register system, meaning your waiter or clerk will need to manually enter your total charge before scanning your card. 

You can tell which establishments do this because you will probably get two receipts – one issued by the establishment (listing what you bought and the items’ prices), and one printed by the card reader (usually just listing the total). Since these two items are registered separately, there is a chance that the person entering your total entered the wrong amount.  This is usually done accidentally, but it means you pay more or less than you should have paid.

If you look at the two receipts immediately, you will catch the error and the store can make the correction while you are still there by voiding the first transaction and creating a corrected one.  However, often the receipts go into the shopping bag and you may not notice the discrepancy until you get home.  You can make the correction later by comparing your “original” receipt with your bank statement and bringing both to the establishment to prove the error. Of course, this is only possible if you kept the true receipt listing what you bought, how much you were supposed to pay, and the time stamps on both the receipt and the bank statement showing it was the same transaction.

Transaction Processing Time

When you make a transaction, the establishment you are buying from needs a “middle man” to contact your bank or credit card company to actually transfer money. This is called “Payment Processing”, and there are a few ways it can happen.

If you are working with bigger companies, the payment will usually process immediately – you can see it appear on your credit card transactions or bank statements immediately. However, It is very common for online stores to use bulk payment processing, which means all payments process one or two days after the purchase was made (this can be a lot cheaper for smaller stores, since the payment processors have lower fees for batches). This can also happen with larger in-person stores (such as large grocery chains or gas stations) that may bulk-process orders.

While delays may only have a one or two day waiting period, it can add up if you are checking your bank balance on the fly to figure out how much cash you have. Each small “delayed” transactions can account for huge amounts of overdraft fees if you think you have money in your account but it is really tied up in pending transactions.

The much bigger processing delays can come from anything you might pay with a paper check (such as rent). These only processes after someone physically takes the check to a bank to deposit it, so the processing time is entirely up to whoever you pay. This can also happen with your paycheck – many payroll systems pay only when someone from your company’s payroll department confirms your pay amount, which means when you actually get the cash in your account will differ depending on weekends, holidays, and that person’s workload.

The 10 Minute Reconciliation

Once a month, you should take 10 minutes to reconcile your checking account.  Remember this means you are comparing the amount of money you think you have in your account with what the bank says you have in the account.  If you keep your receipts, this process will go much faster.  Her are four steps to help with your reconciliation task.

• Step 1: Confirm your big purchases match your receipts
  • Do this for your 10 biggest purchases of the month, just to make sure there were no errors.
• Step 2: Make sure all your deposits are accounted for
  • Check all your paychecks or any other transfers that you have received are properly appearing.
• Step 3: Make sure your payments are accounted for
  • Check specifically larger payments, like the week’s grocery trip, or some gifts you bought online – you do not need to be exact.
• Step 4: Record your totals
  • Once you have established your true bank balance, record this number in your spreadsheet for future reference. This helps you later determine how your spending is moving from month to month.

Working With Checks

You might not need to write checks often, but there are still some cases where it comes up! Be sure that any checks you write are also included in your reconciliation, even if they have not yet cleared your bank account. When you write a check to your friend Sue, she has to deposit your check into her bank account.  Her bank then contacts your bank electronically to make sure you have enough money in your account to transfer into Sue’s account.  If you do, then the money is transferred and the check is considered “cleared.”  This “clearing” process could take days or weeks depending on how quickly Sue deposited the check and how long it takes the banks to communicate with each other.

A check will always include:

• Your printed name
• Your signature
• The person or company you are paying
• The date you wrote the check
• The amount, written out in words
• The amount, in numbers
• Your signature
• Your account number
• Your routing number (this number is a unique number for your bank, used with your account number to identify your exact bank account)

Checks can also optionally include a memo, which is a note to remind yourself or the person you’re paying why you wrote this check.

Try It!

See if you can identify how to properly fill out a check. In this example, your name is Mark Brookshire, and you are writing a check to City Cable Company on April 18, 2019 for $142, to pay for your March bill. Drag the elements from the right side onto the place on the check where they belong.

Pop Quiz

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Challenge Questions

1. What do you understand by the term account reconciliation?
2. Why is it important to do an account reconciliation each month.
3. How might a financial advisor help?

When you are getting your financial records organized, it is important to keep track of your spending, and with your spending comes receipts.  If you think about a typical shopping trip, it is easy to accumulate several receipts quickly as you shop at different stores, stop for a bite to eat, and fill up your car with gas.  Saving receipts can add up to a lot of paper very quickly, so some of the most common questions beginners are faced with is “Which receipts do I have to save?” and “How long do I need to keep them?” 

The Four Receipt Criteria

When you make a purchase, you will probably be tempted to crumple up the receipt and throw it in the nearest recycling bin as soon as possible. But before you toss it, go through this mental checklist:

1. Will I want to return this purchase later?
2. Is this purchase accounting for 10% or more of what I expect to spend this month?
3. Do I need this receipt if something breaks?
4. Do I want to claim this purchase on my taxes?

This might add an extra second to your transaction time, but that second can add up big time!

Receipts for Returns

This is the easiest decision.  In almost every case, you will have a very hard time returning an item to the store if you do not have a receipt to prove you made the purchase.  This means that for clothing, appliances, and any item that could be defective or break, you will want to save the receipt. 

How long should I save them?

Returns are usually accepted only within 30 to 60 days of the purchase, so you can generally throw these out the next time you do an “account reconciliation” – a few minutes you spend each month making sure there are no errors in your credit card statement or bank balances.

Receipts you are saving in case of returns can also be saved separately from your other more permanent financial records, making it easier to throw them away regularly.

10% Purchase Receipts

If you think this purchase will account for 10% or more of this month’s spending, you should keep the receipt for that month’s account reconciliation. Since the dollar amount spent for these purchases is large, you will want to double-check the receipt against the stated purchase price to make sure you weren’t overcharged.

How long should I save them?

If you do not need these for tax reasons, you can safely throw these away as soon as you finish your account reconciliation.

Warranty Receipts

When you purchase electronics or some types of repairs by a licensed professional, the product or service will often come with a warranty. A “warranty” means they promise nothing will go wrong within some time frame. If something breaks or there is a defect in the warranty period, the manufacturer will usually replace it free of charge.

Warranties cover items such as a new TV or cell phone, car repairs done by a licensed mechanic, a new video game console, and other expensive items.

How long should I save them?

If the product comes with a warranty, you will want to keep the receipt plus proof of the warranty for as long as you own the product.  If you have a service performed which comes with a warranty, you will want to keep the service paperwork and warranty for the life of the warranty period.  Find a safe place in your home, such as in a filing cabinet, to keep this paperwork organized.  You’ll be grateful you have it when something goes wrong.

Tax Purchases

You might be surprised at what types of deductions you can claim on your taxes. Paid any tuition or job training? You can claim it! Did you need to buy something required for work, like a uniform? You can claim that too! Depending on where you live, you might be able to claim what you spent on public transit, improvements to your house, and much more.

If what you bought can be claimed on your taxes, you need to keep your receipts much longer, and it is a lot more important to keep them organized. You’ll be grateful you have it when something goes wrong.

How long should I save them?

If you claim something on your taxes, you need to keep the receipt for at least 7 years. This is the threshold for the IRS to audit your tax filings. Then if the IRS does decide to audit you, you will have the necessary paperwork to show that you made those purchases. At the end of that 7-year period you can ceremoniously throw away all the receipts from 7 years ago to make room for a new batch!

Electronic Receipts

Many retailers now give the option to have receipts emailed to you electronically. If you take this option, you can set up folders in your email account where you can move everything quickly and easily for future reference – without having to worry about paper files.

Try It!

Try matching the following receipts to the category for how long you should save them. Some items can fit in more than one place!

Pop Quiz

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Challenge Questions

1. When was the last time you received a receipt. Did you check it and did you keep it?
2. Have you ever received the wrong change?
3. Have you ever returned a product to a store. Were you asked for a receipt?
4. Why might the IRS expect you to keep receipts?
5. How might keeping your receipts help you with your spending plan?