If you know something about personal finance, you understand how complicated it can be to make sure all bills are paid on time, that you are fully insured, and that your credit is healthy.

Juggling the different aspects of your finances usually means savings and investing takes a back seat to everything else on your plate. This is one of the reasons why so few people under the age of 35 have any real savings. Luckily, there is one easy technique you can use to make sure your savings are always growing:  Pay Yourself First.

Savings First, Bills Later

Most people start the month by paying all their bills, budgeting some cash for having fun or buying something extra, and then finishing by putting any cash remaining into savings. When you use the pay-yourself-first model, the order of these steps is flipped.

Here’s how it works.  On every payday, start by taking out money for savings and put it directly into your savings or investing account. Most banks have accounts that will let you do this though automatic transfers.  This is one banking service that you should definitely take advantage of.

Once your savings is taken care of, use the remaining cash to pay your bills.  Any money remaining can be used for fun and leisure. This method is a no excuses savings approach.  No matter what else is happening in your life, you are paying yourself by contributing to your savings.  This habit ensures that your savings and investments experience a steady growth rate.

Pay Yourself First in Action

Here is how it works:

1. Set up automatic transfers from your checking account to your savings account every month, ideally just a day or two after you normally get your paycheck. This is the paying yourself step.
2. Pay your rent, credit cards, and any other bills for the month.
3. The remaining cash is “free”. Use this for going out with friends, buying something you want, or contributing even more to your savings.

Why This Is Important

You already know the importance of having a well-developed budget or spending plan. The downside is that these require constant vigilance. On a regular basis, you should be using your receipts and account reconciliations to adjust your spending plan to match your actual spending. In the real world, very few people follow through on this for more than a few months at a time, even with the best intentions.

By always setting aside savings before dealing with any other expenses, you will ensure that it will be growing, regardless of what happens to anything else. This is the most effective way to save since it means you cannot “cheat”.

Do I Still Need a Budget?

Using a “pay yourself first” savings strategy is not a replacement for maintaining an up-to-date budget or savings plan, but it will make the process much easier.

Without this strategy, your budget or savings plan requires time and attention. You need to account for your income, keep an itemized list of your bills, budget for food and groceries, and finally see how much is left over for savings.

By paying yourself first, you no longer need to worry about setting aside money for savings.  This is done automatically before you have to think about the rest of your budget. Simply knowing that you are automatically building a large savings cushion to deal with emergencies, such as unplanned car repairs, lifts a ton of stress from your shoulders.

Best of all, since you know that your savings is already accounted for every month, your leisure spending will be guilt-free, so long as you use cash and avoid making too many purchases on your credit card. Your budget or savings plan is transformed from a task master, dictating what you can and cannot do each month, to a partner. Updating your budget will be easier since you no longer need to worry about having enough money left over to save.  If you want to increase the amount of money you are saving, you simply need to increase the amount of your automatic transfers.

How Do You Pay Yourself First When Cash Is Tight?

Paying yourself first makes sense if you have a balanced monthly budget, but what happens if you are behind on your bills?

With a pay-yourself-first savings strategy, your savings always comes first. This means dipping into savings is almost entirely off-limits. By following this strategy, you would rather pay a bill a month late than take money from your savings to pay it off.

This is also why the strategy works. The amount you save each month is entirely off-limits for any other type of spending. The only exception is if you are severely behind on debt payments and have no other options.

Cutting Spending

Building this mentality of “save first” is important. Everyone wants to save, but often people treat a savings account as just another source of money.  For example, people want to avoid credit card debt, so if there is something they want to buy, they know it might be irresponsible to buy the item on credit.  Instead, they will just dip into their savings since that money is already theirs.

This is dangerous thinking because withdrawing from your savings is a loan. You are borrowing money from your future self.  Unlike a credit card with required monthly payments, you are unlikely to pay back this loan to yourself, damaging your long-term wealth. By adopting a pay-yourself-first strategy, it removes spending decisions. If you really want to buy something today, use your credit card. If you do not want to incur the finance and interest charges from the loan, then re-evaluate if the purchase is really worth it!

Making Pay Yourself First Work

One way to make pay yourself first work is by keeping less of your savings as cash.  This helps prevent withdrawing cash unless it can’t be avoided.

One of the best ways to do this is by converting a high percentage of your savings into investments like stocks, bonds, and mutual funds instead of simply having cash sitting in your savings account. By moving your savings into investments, you kill two birds with one stone.

Less Liquid Savings

A “liquid asset” is something that can be quickly and easily converted into cash and spent. Savings accounts are extremely liquid assets, which is why some people have a hard time building up their savings fund: cash can be spent. By converting a large percentage of your savings account directly into investments like stocks, bonds, ETFs, and mutual funds, there is an extra step you’d need to take before the cash could be spent. Since you would need to sell your assets first in order to spend the cash, you are less likely to do so unless the spending is extremely important to you.

Making Money Work

Another advantage with turning savings into investments is that invested money will, on average, grow much faster than money in a savings account. Instead of receiving only 1-2% of growth from a savings account, you could see returns of 8-10% by investing in index funds or diversified mutual funds. Investments will help your savings grow much more effectively.

Skin in the Game

When you purchase investments, your brain reacts just as it does when you pay a bill.  Your mind sees this as “spent money,” not money that can be used to make purchases.  As your investment portfolio grows, it becomes exciting to watch your money grow, and you will be paying closer attention to how your money works for you.  This encourages increased saving and investing. Over time, this helps build a nest-egg of wealth you may have otherwise simply spent.

When Should I Use My Savings?

A pay-yourself-first strategy includes a mindset of making withdrawals from your savings account as infrequently as possible.  However, there may be times when making a withdrawal is beneficial.

It is okay to make withdrawals when

1. Investing in a physical asset, like buying property or a vehicle
2. Investing in a paper asset, like stocks, bonds, or mutual funds
3. Starting a business
4. Paying off big debts, like student loans or a mortgage

You should not make withdrawals when

1. You want to make a purchase you “deserve” but don’t have the cash for
2. You experience an emergency which will take fewer than 3 months to pay off without dipping into your savings
3. Buying holiday and birthday gifts.  (Making these purchases should be part of your normal spending plan or budget.)

Get PersonalFinanceLab

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=148]

Challenge Questions

1. What do you understand by the concept Pay Yourself First or sometime known as Save first, before you spend?
2. How might this help you budget?
3. If you were going to start Paying Yourself First today, how would you go about it?
4. What are the advantages of Paying Yourself First?

If you find yourself over your head in debt, there is always a light at the end of the tunnel. Credit counseling agencies, both for-profit and non-profit, exist in every state to help people build a clear, workable path back to a healthy personal financial situation.

If you do need the help of a credit counselor, this is what you can expect.

What is Credit Counselling?

Credit counseling is a service offered to help people bring their personal finances under control. A large part of what credit counselor involves is purely educational, usually with many free resources available. Just like your health, big problems are best addressed with prevention before the problem gets out of control. If you are reading this, you are already working through some course work that would be similar to what would be offered by a credit counseling agency.

Unfortunately, most people reach out for help only after debts start to spiral out of control. At this point, you will need to meet one-on-one with a credit counselor to chart a path forward and get yourself out of debt.

There are three main tools applied by credit counseling agencies before bankruptcy enters the discussion: budget building, debt management planning, and debt settlements.

Who are Credit Counselors?

Credit counseling is loosely regulated by FINRA, the Financial Industry Regulatory Agency, which sets rules for what can be advertised and advised. Reputable credit counselors have a professional certification, usually through the NFCC, the National Foundation of Credit Counselors.

There are both for-profit and non-profit credit counselors.  The NFCC usually works with non-profit institutions. The cost of getting credit counseling will vary from agency to agency, but it usually starts with a flat fee for your initial consultation, plus a percentage of the total debt settled if you require more help.

Budget Building

Building a budget is the first step when working with a credit counselor. You will usually sit down for a 1 or 2 hour meeting to discuss your current financial situation. This includes reviewing your total debt load, income, expenses, and how you are currently spending your money.

our counselor will review your financial information with you and recommend some educational materials or courses that present some advanced techniques for discharging your debt as quickly and cheaply as possible. They will also work with you to build a new budget based on what you can afford.

How Is This Different from My Own Spending Plan?

If you already have a strong budget or spending plan and have simply fallen behind on payments because of emergencies or income loss, this step of the process may not tell you more than you already know.

Statistically, most people do not have a budget or a spending plan in place that gets reviewed and updated with any regularity. One of the biggest advantages of speaking to a credit counselor is that this is a completely unbiased third party who is working to get you out of debt. The counselor will help create a stronger budget, based purely on facts and figures, not influenced by emotion or panic. Working with a certified credit counselor is also a good way to learn about tax incentives, subsidies, or other debt relief programs in your state that you may not be aware of.

Debt Management Planning

If your debt problems cannot be addressed by revising your budget, the next step is creating a debt management plan.

With a debt management plan, your credit counselor will work directly with most of your creditors, usually excluding secured loans like mortgages and car loans. Your credit counselor will negotiate to get as many late fees and finance charges waived as possible and will set up regular monthly payments to pay off the debt.

Instead of paying your creditors directly, you now make one monthly payment to your credit counseling agency, who then distributes that payment to each creditor according to the terms they negotiated.

Debt Management Plan and Debt Consolidation

Debt management planning is superficially like debt consolidation, where you take out one big loan to pay off many smaller debts. Debt consolidation is often also part of the credit counselling process, and your credit counselor will be able to help decide if it should be part of your payment plan.

When you work with credit counselors, their goals are to help you repay your debt as fast and cheaply as possible. They usually discourage taking out additional loans, unless that is the only option available to preserve your credit rating.

Advantages of Debt Management Plans

In theory, your debt management plan will not be very different from something you could build yourself, if you are able to successfully negotiate with your creditors.  However, it does have some distinct advantages:

• Experienced Negotiators. Your credit counselor is a professional credit negotiator, and so he/she knows the right buttons to push to get your fees lowered as much as possible.
• Relationship with Creditors. Your credit counselors already have established channels of communication with most creditors, so they know exactly who to talk to in order to get things moving forward. This can include things such as changing payment due dates to get everything all on one schedule.
• Leverage with Negotiations. When your credit counselor is in contact with your creditors, your creditors know that you are in a tight spot financially and are not making up some story over the phone. Your creditors are not interested in driving you into bankruptcy, since that means they do not get paid. They usually are more flexible when negotiating with credit counselors compared to when you speak with them directly.
• Clear Reporting. Your credit counselor will send you monthly reports about the exact status of all your debts, including how quickly each is being paid off.
• Lower Total Payments. In the lesson on juggling bills, we showed that it can be cheaper to pay off some bills completely instead of making minimum payments on everything. Your credit counselor knows this too.  He/she will optimize the payment schedules to pay off the most expensive debts the fastest, minimizing the total amount you need to pay.

Restrictions of Debt Management Plans

Debt management plans are not always a simple solution, and they may require some tight restrictions on what you can and cannot do.

• No New Credit. When you enter a debt management plan, it appears on your credit report. (It doesn’t affect your credit history or your credit score.  It just shows that you agreed to a debt management plan.)  This serves as a warning to creditors that you should not be extended any new credit. If you do get a new line of credit anyway, your credit counselor will terminate your debt management plan, putting you back at square one.
• Cancel All Credit Cards. Most household debt that requires credit counseling comes from credit cards. Debt management plans require you cancel all open credit cards and stipulate that you cannot open new ones until your current debt is paid off.
• Tricky Relationship with Creditors. Just because you are using a debt management service does not mean your creditors will stop calling. Once you are on a plan, most credit counselors will advise you to cease all communication with your creditors.  If one calls, you should provide the creditor with the credit counselor’s name and number and let him/her handle it. If you do speak with your creditors and say something that conflicts with the negotiations your counselor has been working on, it could sink your whole plan.

Debt Settlement

If your level of income will not allow you to pay off your debt reasonably by using a debt management plan, the next step is debt settlement. With debt settlement, your credit counselor will set up a monthly payment plan for you, but instead of paying your creditors, the money they receive from you goes into a separate savings account.  Then the counselor enters into “hardball” negotiations.  The position they take with your creditors is that you are on the verge of bankruptcy, and your creditors can either reduce the total amount owed to something you can afford or risk not getting paid at all if you go bankrupt. Once your creditor and your counselor come to an agreement on that new lower amount, your creditor gets paid from that savings account you have been paying into.

Advantages of Debt Settlement

Debt settlement is the end of the road when it comes to paying off your debts. The only step farther is declaring bankruptcy.

The major advantage debt settlement has over a regular debt management plan is that the total amount you must pay will be significantly reduced. This includes reducing or eliminating the finance charges.  It can also reduce the principal owed.  No other non-bankruptcy solution will reduce your principal owed. At this point, your creditors are trying to take whatever they can get, hoping to not be left with zero dollars in payments if you go bankrupt.

Disadvantages of Debt Settlement

Every other debt management solution works to preserve your credit rating, keep your creditors happy, and keep your budget on track. Debt settlement does not. It comes with some unique disadvantages, making debt settlement your last option.

• Immediate Damage to Your Credit. With debt settlement, you immediately stop paying all creditors while the negotiations are in progress. This means your creditors will immediately start reporting you as delinquent on all of your accounts. This will do a lot of damage to your credit.
• Long-Term Damage to Your Credit. Your credit report shows one of three statuses for each of your credit accounts:  OK/Paid, Late/Delinquent, and “Settled.” A “settled” status means the amount owed was discharged through a debt settlement negotiation. This is better than an unpaid account, but it is nowhere near as good as “OK/Paid”. This will remain on your credit report for at least 7 years.
• Increased Harassment. Your creditors will not be happy when you stop making monthly payments, they and will try to bounce claims off you and your credit counselor at the same time, trying to “catch” inconsistencies in the way you are managing your debt.  This will improve their bargaining position. Your credit counselor will usually advise you NOT to answer your creditors at all while debt settlement negotiations are in progress.
• Credit Restrictions of Debt Management. You will be required to close your credit cards and will be prevented from opening new lines of credit while the negotiations are in progress.

Predatory Credit Counselling Services

If you enter debt settlement proceedings, your credit counselors will usually be paid a fee based on a percentage of the total amount of debt that they are able to get “cancelled”. For example, if they negotiate a $1000 debt down to $700, they may charge you $150 as a fee for the service.

For large debt loads, this can be a real money-maker. This opens the door to potential predatory practices. A predatory credit counselor will usually advise debt settlement as a first step, or suggest it before exploring other alternatives. There are plenty of cases where debt settlement is the best option, but if it is the first suggestion, you should get a second opinion.

Get PersonalFinanceLab

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=144]

Challenge Questions

1. What do you understand by the term credit counselling?
2. Using the internet, research the two credit counselling bodies mentioned in the text, providing an overview of what they do and how they help people?
3. What restrictions do people take when addressing their debt?
4. What are the advantages and disadvantages of debt settlement?

If you start falling seriously behind on your bills, simple prioritization and negotiation may not be enough to help you catch up on your debt.  Even in this situation, you still have some options available to keep your finances under control.  One of the most straight-forward options is debt consolidation.

When to Consider Debt Consolidation

Most adults have at least half a dozen creditors, such as credit card companies, banks for a mortgage, car loan providers, student loan providers, and basic utility companies. If a unexpected event occurs, such as losing your job, you may start falling behind on payments for several creditors all at once.

Prioritizing your bills and negotiating with your creditors can get most people through tight money situations for a month or two, but it can only work for short periods of time.  After a couple of months, even the savviest negotiators will find themselves getting stuck with mounting late fees, finance charges, and angry calls from creditors. Each late payment also affects your credit score, which will hurt your chances for getting other lines of credit in the future.

What It Means to Consolidate Debt

This is where debt consolidation comes in. Consolidating your debt means taking out one big loan and using that money to pay off all outstanding balances from your previous loans.

While taking out a new loan may not seem like such a good solution, there are several reasons to consider a debt consolidation loan when you find yourself in hot water.

Preserves Your Credit Rating

Every time you make a late payment on your credit card or on another loan, your credit rating will take a hit. Miss enough payments and you will have a very hard time securing any loans, even years later.

On the other hand, if you consolidate your debt and pay off your consolidation loan quickly, your credit rating can actually improve. Paying off all the outstanding balances means no more negative reports on your credit history. Debt consolidation acts like any other loan.  Making payments on-time will boost your credit rating.

Keeps all your creditors happy

Remember: the most important concern for any of your creditors is that they get paid, and the sooner the better. Consolidating your debts quickly and getting all outstanding balances paid off builds goodwill with your creditors. This means they will usually be more flexible in the future if you hit another rough patch because they know you will come through.

Lowers Your Payments

Once all your outstanding balances are paid off, finance charges and late fees are gone too. This means the amount due each month is just a single payment towards the principal and interest, the same as for any other loan. The interest rate on consolidated loans is almost always lower than the late fees and finance charges you will get from each of the individual outstanding balances.

What this means for you is that a consolidated loan will keep your credit healthy and growing, and it will lower the number of monthly payments required to pay off the same principal in debt.

How to Consolidate Debt

Consolidating debt means taking out a loan to pay off other outstanding balances. Like all loans, there are two main types to consider:

Unsecured Loans

Getting an unsecured debt consolidation loan is very rare. Most creditors are very wary of people who need debt consolidation loans because it means they have already let their debts get out of control.

One unsecured loan type to consider is simply using your credit card to pay off all other balances.  This will require you having a sufficient credit limit on your card. If you already pay most of your bills using your credit card, you are consolidating your debts without even realizing it. Many people prefer this simply to keep all their payments in one place, making them easier to track.

The biggest downside of using credit cards or other unsecured loans to consolidate your debt is the finance charges. Unsecured loans almost always charge higher interest rates. This means you might not be saving much money by consolidating everything on your credit card rather than just making minimum payments.

You also cannot use your credit card to pay off other credit card debt. If credit card debt is one of your problems to begin with, you probably will not be looking at unsecured loans for consolidation.

Secured Loans

Most types of debt consolidation loans involve a secured loan, usually a home equity loan, also called second mortgage. This means you will use the equity built up from your home to take out a new loan. The amount of debt you can consolidate is dictated by how much equity you have to use as collateral. If your debts are greater than the equity you have built up in your home, you are considered insolvent.

If you are a renter, you won’t have a home equity loan as an option.  However, there are some types of secured loans that use your car or other property as collateral. Unfortunately, these usually fall under “Payday Loan” or “Pawn Shop” type lenders, which can charge excessively high finance charges. Taking these types of loans is more likely to drive you farther into debt than to help pull you out. If you are not able to find any other type of consolidation loans, you should investigate credit counseling services.

Risks of Consolidating Debt

Debt consolidation is not a “get out of debt free” card. You are simply using existing credit lines and equity to pay off a temporary hardship and preserve your credit rating.

Risks with Unsecured Loans

If you simply transfer other outstanding debts onto your credit card, you now must grapple with your new credit card debt. Credit cards typically charge fairly high interest rates compared to secured loans, which means the interest you pay will still be very high.  The interest charge itself could be nearly as much as you would be paying in late fees, but you would not be hurting your credit rating.

If you can only afford the minimum payments on your credit card, you are stretched dangerously thin.  Any other financial emergency could force you into default.

Risks with Secured Loans

Consolidating your debt with a secured loan is cheaper than using your credit card or an unsecured loan. This makes this type of loan a more attractive option, but it comes with its own serious drawbacks.

First, you are wiping out your equity. This means all the value you have been building up in your mortgage (or any other property used as collateral) is gone.  You will need to completely pay off the consolidation loan to get it back.

Second, your finances are still stretched very thin. Missing your payment on a consolidated secured loan is the same as missing a payment on your primary mortgage.  It could put your whole house into default and trigger foreclosure proceedings.

Taking Action

If you are in a position where you cannot juggle your bills or negotiate a 1-2 month extension with some creditors, you need to take action quickly in order to get out of debt and keep your finances healthy.

Consolidating your debt is often one important part of that process, but it is not a decision to make without consulting experts.  If you are considering consolidating your debt, speak first with a not-for-profit credit counseling agency to fully explore your options. Debt consolidation is usually one action taken as part of a larger personal finance plan, not an action to be taken on its own.

Any time you are working with debt, the clock is ticking. It is always better to ask for help sooner rather than just panicking later.

Get PersonalFinanceLab

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=142]

Challenge Questions

1. Using examples, what does it mean to consolidate debt?
2. What are the advantages of consolidating debt?
3. Are there any disadvantages to consolidating debt?
4. What is the difference between a secured and unsecured loan?
5. What are the current loan rate percentages being offered in the market place today for a loan of $10,000 over 3 years?

It happens to everyone: a monetary emergency happens, such as a car breakdown, draining your bank account. Bills are still coming in, and you know that you will not have enough money to pay for your debt obligations this month.

One of the first goals when developing a strong personal financial plan involves avoiding these scenarios by having a savings cushion, but this is not always possible. How can you get out of this situation with the least pain?

Example Scenario

For the examples in this article, we will assume that you have enough groceries for the month, you have $1000 in your checking account, and your next paycheck is a month away. You just received all of your bills today:

 The total of all these bills is $1630 – way above what you can afford. Instead of getting worried or depressed, develop a plan of action.

Evaluate the Damage

The first step is to take a look at what will happen for each of these bills if they are not paid. This is a good way to prioritize which bills to tackle first.

• If your rent is unpaid for one month, you will get charged a late fee, but you probably won’t be evicted.
• Utilities usually cannot be turned off unless there are several months in a row of failed payments.
• Your internet connection probably will take a month or two of failed payments before your service provider shuts it off.
• If your cell phone bill is unpaid, your provider most likely will shut off your phone within a few days.
• Missing a credit card payment will not automatically put you in default, but you have a high interest rate and a late fee to deal with. Plus missing a credit card payment can really hurt your credit. This also applies to your car loan.
• Missing your student loan payment can put you in default fairly quickly.  This is the stickiest kind of debt.  Not even bankruptcy will remove it.
• Missing a payment on your car insurance might void your policy. And if you lose your insurance, you can no longer legally drive to work.
• Missing your health insurance payments might also void your policy, although there are some protections against this, and getting back on the plan might be expensive.

By knowing those facts about your different bills, now we can make a “ranking” of how important it is to keep each one of your creditors happy in the short term:

This priority will shift a lot if you are facing multiple months of being behind on your bills. For example, if you are under direct threat of eviction, rent might jump near the top of the list.

Explore Your Options

Next, spend a few minutes to think about any other ways you can scrounge up enough cash to make all your payments this month. We discuss this in detail in our article on Short-Term Financing.

Borrow from Friends or Family

Borrowing money from friends or family members might be able to help bridge the gap. This is usually the cheapest and easiest way to get money to pay your bills, but many people are uncomfortable or unable to borrow money from the people they know.

Credit Card Financing

One option is to pay off your credit card first and then use the line of credit available to pay off all your other debts. You could then pay off the credit card balance with your next paycheck. This is the second fastest and easiest method. This will keep all of your creditors happy, and you will not accumulate much interest before your next paycheck, making this the least expensive option available.

Short-Term Unsecured Loans

A short-term unsecured loan is the type of loan you can ask for at a bank. Whether it is granted or not depends on your credit history, the amount you need to borrow, and the policies of the bank itself. If your bank offers you a loan, this is another workable solution. (This is NOT a payday loan. See our article on Short-Term Financing to tell the difference.)

Divide Your Paycheck

In the real world, dividing your paycheck is the most common course of action if the first 3 options fail. Some of your bills are completely non-negotiable and will cause major problems if you cannot make the monthly payment.  Pay those first.  Then for the remaining bills, divide up your paycheck proportionally and hope your creditors do not complain too much until next month.

Pay Off What You Can

Paying off only what you can also happens in the real world, but is more rare. When using this method, instead of dividing up your paycheck proportionally, you pay off several of the bills in full, leaving others to be completely unpaid until next month. The creditors you do not pay off hate this.  You may get angry phone calls or letters, and it could seriously hurt your credit.

Take Action

If you can borrow some cash, use your credit card, or get a line of credit from your bank, that will be the way to go. If not, you will need to determine which hurts less: dividing your paycheck or paying off what you can.  Let’s take a look at how this works.

Step 1: Subtract the Non-Negotiables

The top 3 things on our list are non-negotiable.  Any lapse in the bills will cause termination of your service entirely.

Non-Negotiable Bills = Health Insurance + Car Insurance + Cell Phone

= 250 + 30 + 50

= $330

We know that no matter what, we need to spend this $330, leaving us with $670 in cash for the remaining bills.

Step 2: Calculate Extra Costs Charged for Unpaid Bills

We want to decide if we are diving our $670 proportionally, or paying off a couple of bills entirely. To see which is best, we first need to know how much extra cost will be applied to the remaining bills if we wait until the next paycheck to make a payment

 $1,300 in bills today will grow to $1,549 next month if unpaid, or $249 more than it would be if we could pay everything today. We can see the biggest hits are coming from rent and credit cards.

We are not getting charged extra for missing payments for the student loan and the car loan, but missing a payment will damage our credit history, and we will accumulate more interest on the principal balance. We will estimate the damage to our credit history being $60 each for the credit card, student loan, and car loan payments.

There is also a chance that our landlord and utility companies will report the missed payments.  We will assume there is about 1/6 chance, so we will estimate a “credit damage” amount of $10 for each of those bills.

This means the total damage done by missing every payment this month is $459.

Step 3: Calculate Cost if Paycheck Is Divided

Next, we want to see what our cost will be if we divide our paycheck proportionally. This means we are not paying any bill in full.  We are looking at the proportion each bill represents of the total amount we owe, and dividing our paycheck accordingly.  We will still get charged late payments and some interest. However, we will assume that there will be 1/4 the amount of damage to our credit for a partial payment compared to making no payment at all.

 We are paying $150 in late fees alone. Now we factor in the interest charges and damage to our credit that goes with this payment:

To calculate how much this is costing us, we can add together our total late fees, total interest charge, and total damage to our credit:

Total Cost = Late Fees + Interest Charges + Credit Damage

= $150 + $53.57 + $52.50

=$256.07

The total damage is $256.07, which is just $202.93 better than paying nothing at all, but still a big amount.

Step 4: Compare with Paying Off Big Credit Debts First

What if instead of dividing up our paycheck equally, we just pay off what we can afford, and leave the rest? To prioritize, we can take our $670 remaining, go down the list of priorities, and simply pay them off.

 Now we have an unhappy landlord and an unhappy internet service provider, but our other bills are paid. We can now compare this option to how much damage skipping these bills entirely would do:

This gives us a total damage of $149.50, saving over $100 compared to dividing up our paycheck equally. We even still have $50 remaining.  Applying the $50 to the internet or rent bill would remove some of the credit damage and the interest charged, saving even more money.

Our calculations show that paying off most bills completely and leaving a few unpaid will be better dollar wise.  You will save money on late fees, interest charged, and damage to your credit.  However, the reason most people still divide up their paycheck and pay a little to each creditor when faced with a cash shortage is due to the human factor.  Every creditor who is not paid will send you emails and make phone calls as soon as your payment is late, demanding payment as soon as possible.  So people try to minimize the damage from each creditor instead of focusing on minimizing the damage from every creditor. By keeping the big picture in mind, you will do your spending plan a huge favor!

You can download a spreadsheet showing all of these calculations, and even change the values to match your own bills, by clicking here.

Get PersonalFinanceLab

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=138]

Challenge Questions

1. What reasons might there be that could cause someone to miss paying a bill?
2. In your opinion, how important is it to have an emergency fund?
3. After reading the text, would you pay a small amount to each creditor or prioritize and look to eliminate one bill at a time?
4. What are some of the effects of paying your bills late?

Every person makes hundreds of purchases every month. Think about how many individual items you choose when buying groceries, how often you eat out or use a vending machine, or how often you buy new clothes. Each purchase has a reason, but each purchase costs money.

One of the cornerstones of strong personal finances is knowing why you buy what you do and knowing how to research your purchases in advance.

Why We Buy What We Do

Coke or Pepsi? Large coffee or medium? Prepare your own bag lunch or go out to eat? You will make thousands of tiny decisions every month about how your paycheck gets divided.

It is not possible to carefully consider every single purchase you make.  This would lead to decision fatigue. Decision fatigue happens because every choice you make takes some brainpower. As you spend more time and effort considering each choice, you will get worn out very quickly.  This is why most people spend a lot more time researching “big ticket” purchases than every item in their grocery cart.

Once you break down your spending with a spending plan, you will see that all your minor purchases add up very fast. That’s why it is important to understand why you make each of those small purchases.

Advertising and Spending

You are susceptible to the effects of advertising.  Everyone is. Most people think advertising does not really affect them much, but no matter how savvy you are, you will be affected by ads.

When you are deciding whether or not to buy a product, you already have some pre-formed opinions about what benefits you will receive compared to the price you are paying. Where did those pre-formed opinions come from? They came from several prior experiences you’ve had that allowed you to interact with the product in rational and emotional ways.  Advertising was at work.

A successful ad is able to do three things.  First, it attracts your attention.  Bright colors, interesting people, music, humor, bold words, and familiar experiences are all at work to capture our attention. Next, the ad gets the name of the product stuck in our heads somehow. Third, advertisers put a positive spin on their products to convince us that this is something we truly want or need.  A good ad is able to hook your emotions and bypass your brain. Then when you see those products while you’re shopping, you are more likely to make impulse purchases rather than comparing products and choosing the one with the best value. 

Advertising has the biggest impact on our smaller purchases, where we only spend only a few seconds weighing pros and cons. A simple product endorsement from a social media website may be the reason you buy Product A instead of Product B. 

Previous Experience

Our own previous experience is the opposite of advertising.  We have used a product previously, and so we know exactly how well it works and the value it brings relative to cost. Smart shoppers should not rely solely on previous experience to make purchasing decisions.  Buying certain products out of habit means you are not taking time to compare one product to other available alternatives. 

Most of us have an older relative who has used the same products or visited the same restaurants for the past 30 years, even though newer, better alternatives are now available.  This happens because shoppers fall into spending ruts, where a positive previous experience has switched off the part of the decision making process where you consider alternatives.

Peer Pressure

When it comes to spending, peer pressure is not always a bad thing. Peers will share their personal experiences with a product or service, allowing you to gain knowledge of what you are buying before wasting your money. Getting a product endorsement from someone you trust is one of the best ways to feel the benefit of the product is worth the price.

On the other hand, peer pressure can also encourage over-spending. If you have more than a couple of friends, once they know you are shopping for a particular product, chances are you will get recommendations from each of them. Each may claim that different products are well worth the cost and the investment. Each friend might be right, but even if they are, buying more items just because they were recommended can really hurt your budget.

Think about watching TV shows.  You might have 4 different friends, each recommending a different TV show, which takes ½ hour to watch one episode. If you take the advice of all 4, you’ve already dedicated 2 full hours to watching TV, before you even get to the shows you privately wanted to catch up on!

How to Spend Your Time Researching

Researching purchases is mostly a time problem.  There are thousands of purchases to consider, but only one of you and only 24 hours in a day. Thankfully, there are some tools that can help with your research, making the process easier for you. 

Use Your Spending Plan or Budget

Before you make any purchase, your need to first decide what money you actually have to spend.  If you have created a budget or spending plan, this usually means looking at what you spent last week or last month and using those dollar figures as a starting point.

Next, decide if you can spend less on future purchases without missing out. For example, you may prefer name-brand products or getting your coffee to go instead of brewing it yourself, but could you save money simply by making small changes?  You might prefer that extra cash at the end of the month more than the drive-thru coffee you purchase in the mornings.

Conduct some personal research to determine how much each item is really worth to you. Try decreasing your grocery or clothing budget by a few dollars each month.  With less money allocated for these purchases, you may be forced to spend an extra few seconds thinking about each item that normally goes into your shopping cart.  Sometimes this is all it takes to save a lot of money in the long run.

Compare Online as You Shop

Most people today have a smartphone with full internet connectivity. If you are shopping at a brick-and-mortar store purchasing items that cost more than $20, it may be well worth your time to do a quick online price-check for those items.

This online price-check provides two major advantages.  First, you will see instantly if you can find the items at a cheaper price somewhere else. If the purchase can wait a few days, you can order online and save money. Second, online shopping sites usually provide user reviews from other people who have purchased certain products. These reviews will educate you on the product’s actual quality, how long it will last, and problems other customers have experienced. 

Delay Purchases

If you decide you want to buy something, there is a simple trick to help you save a huge amount of money.  Delay the purchase.  Simply do not purchase the item as soon as you’ve made up your mind that you want it, even if it is on sale.

Have you noticed when you’re shopping online for certain products that advertisements for those products seem to “follow” you around the internet? Ads for those new shoes you were looking at seem to appear in your email, your news feeds, and in your social media websites.  Let those ads do some of the research for you! When you find an item that you want but do not buy it right away, the ads that are following you will now be showing you some alternatives.  These alternative retailers or products might have better prices or better reviews that you did not see during your first round of research. The biggest advantage in delaying purchases comes by simply cutting out impulse purchases entirely. According to the BBC, most shoppers waste about $800 per year on impulse buys for products that they never really use and never needed in the first place. Delaying your purchase by a couple of days kills that impulse.  By delaying the purchase and killing the impulse, you just saved yourself the entire purchase price, plus you don’t have items around your house that you really don’t need.

Be Wary of Sales and Bundles

A shopper recently purchased a laptop from a major electronics store. It was purchased at a competitive price, was well-researched, and had all the desired specs. At the check-out, the salesperson offered a bundle.  The store would offer a full set-up of the laptop, complementary antivirus software with a 1-year subscription (which the store sold separately for $70), and a 1-year warranty for accidental damage, all for only $60.

This bundle exists at most electronics stores, with similar terms, but it really does not offer much more than simply an increase in cost. The bundle is offered at check-out specifically to give the buyer little or no time to research the purchase before having to make a decision.  This should raise a red flag for shoppers.  In reality, no part of the bundle was a good deal.

• There is no real “set-up” process for new computers anymore. Just entering your name and logging into your home’s Wi-Fi is usually enough to get up and running.
• Almost every new computer comes with a “trial” version of professional antivirus software, which lasts as long as the membership period offered in the bundle. The Windows operating system now includes its own built-in antivirus protection, known as Windows Defender.  And free versions of almost every other reputable antivirus exist for extra protection. Apple computer products also have their own free suite of antivirus software to choose from.
• The accidental damage warranty offered by the store was almost identical to the one already included by the manufacturer of the laptop, providing no additional benefit to the customer.

You can find a similar story behind almost any bundle ever offered at check-out. If you are being offered a bundle deal without being given time to do proper research on what you are buying, you will be better off by opting out and sticking with the purchase you have already researched.

Get PersonalFinanceLab

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=132]

Challenge Questions

1. Why is it important to consider comparison shopping?
2. Other than price, what other factors should you consider before purchasing something?
3. With the use of examples, what do you understand by peer pressure?
4. With your understanding of opportunity cost, how does this apply to purchases?
5. How might delayed gratification and delayed purchases help you with your budgeting?

When you are evaluating how to spend your money, most people make a fairly simple comparison.  If the benefit they believe they will receive from the purchase is greater than the cost, then most people go ahead with the purchase.

When you are working to master your personal finances, you might notice a problem with this idea. There are many potential purchases you can make that you believe are “worth the money,” so you spend money now instead of saving for the future.  In order to change your mindset, you need to start thinking long-term.  By building a toolkit that lets you think about a purchase and how it will impact you over time, you can begin making smarter financial decisions.

Opportunity Cost and Depreciation

When you start to plan for purchases instead of shopping with no plan in mind, you no longer just focus on whether or not a purchase is “worth the money.”  You start to think about how this purchase will impact you moving forward. To make this process easier, start by applying some economic and financial concepts to your purchases.

Opportunity Cost

The opportunity cost of a purchase focuses on what you are giving up when you buy something. For example, if you purchase a new smartphone for $1,000, the cost to consider isn’t just the $1,000 you spent on the phone but other things you could have done with the $1,000 including purchasing other products, saving the money, or investing the money and gaining interest on it down the road. 

When you make an expensive purchase, instead of just thinking about the cash in your pocket, keep in mind that you are making that money unavailable for other wants and needs. If you had that $1,000 currently invested in the stock market, would you be willing to pull it out of your investments to buy the smartphone? What if instead of the latest model smartphone, you only needed to pull out $500 for a 2-year old model, leaving the other $500 to continue to grow?  Would that be a wiser decision?

Amortization and Depreciation

Amortization means you spread the value of a purchase over the useful life of the item instead of counting it as one sunk cost now and then “free usage” until it breaks or you get rid of it. Thinking this way allows you to spread the cost over a span of time.  For example, if you buy a $1,000 phone and plan to use it for 3 years, you could view the cost as $266.67 per year.

Depreciation describes the fact that most items lose value over time. The new smartphone you purchased will start to get slower and less reliable in the coming years. The novelty you got when you first purchased it will wear off the instant a newer model is released.  However, that item still has value.  Your $1,000 new smartphone may only be worth $600 two years later, but it still has value.

More expensive, higher-quality items tend to depreciate in value slower.  This means you are getting more value over a longer lifespan.  Consider this when you are comparing higher-quality and lower-quality items.  It may be worth the extra money to purchase a more expensive item if it will retain its value for a longer period of time.

Combining Concepts

When you plan for a purchase, you should consider a balance of the value of the item, the monetary cost, your opportunity cost, and the depreciation rate of the purchase. The more expensive the item is and the longer you think it will last, the more important this balance becomes.  You’ve learned to look beyond the simple idea of whether or not you can afford it.

Keeping with our smartphone example, let’s assume you we still trying to decide between the $1,000 newest model and a two-year-old model priced at $600. To make a decision, we need the following information:

• On average, people keep their smartphones between 2 and 3 years. We will keep the phone for 3 years.
• We also need something to compare the purchase against.  The S&P 500 stock index has an average long-term return of about 11%.  We won’t be too optimistic, so let’s assume we can invest in the S&P 500 Index Fund (SPY ETF) and receive a return of 8% per year.

Step 1: Calculate Realized Purchase Cost

Our “realized” purchase cost will be the sticker value, plus the opportunity cost. In this case, if we buy the new phone, it costs $1,000 flat. If we buy the older phone, it costs $600, but we are investing that extra $400 savings at a rate of 8% for 3 years.

Using our compound interest calculator, we can see that our $400 will grow to $504 – an extra $104. Since this is cash we would not otherwise gained, we can subtract it from the purchase cost.

Now we are comparing a $1,000 new phone with a $496 older phone.

Step 2: Amortize the Cost

Next, we can amortize the cost over the phone’s useful life.

• Our $1,000 phone costs $333.33 per year for 3 years.
• Our $496 phone costs $165.33 per year for 3 years.

We can see that the older phone is still much cheaper per year, but we knew that before. We also knew that we value the $1,000 phone more than the $600 phone, or else we wouldn’t have needed to think about the trade-offs so much. The purpose of amortizing the cost is to give ourselves a yearly number that we can depreciate – what this phone is costing us per year.

Step 3: Depreciate the Value

Next, we need to figure out how quickly the value of our phone will disappear. If we use market data to assess the decay rate of our smartphone, we can see that our $1,000 phone will decay to $600, (a $400 decrease) within 3 years, 60% within 2 years, or 30% per year.

At this point, we have not yet specified how much we personally value each of the phones in front of us. It could be that the new phone has some amazing new feature that we would be willing to pay $3,000 for, and the $1,000 asking price is a steal. Or it could be that our value of the phone is just a little bit more than the asking price. When you depreciate the value of a phone, you are not depreciating the money it costs you to buy it.  You are depreciating the value you place on owning it.

Unfortunately, right now we do not know how much we value these phones (either by themselves or relative to each other). Instead, what we will assume is that we value the phones at least as much as they cost us. This means we will take our amortized value and depreciate that to give ourselves a minimum amount we must value these phones to even consider buying them.

These totals are less than the price, so now we can find our break-even value for each phone.

The break–even point is when the cost of the phone is equal to how much you value the phone, including how much value it loses over time. Regardless of the alternatives, you would not buy a phone for a higher cost than you value it.

New phone: $1,000.00 – $699.98 = $300.02

This means we need to factor in $300.02 in lost value over the life of the phone by adding it back in to our purchase price.

$1,000 + $300.02 = $1,300.02 break-even point

For us to consider purchasing the new smartphone, we need to value it at $1,300.02 or more. (Notice we are not even comparing the new and old phones.)  This is the minimum value we need to put on this phone for it to be an option. If we cannot say that we would get $1,300.02 of value out of the new phone, our decision is over.  Do not buy it.

Old phone: $496.00 – $346.39 = $149.61

 This means we need to factor $79.12 in lost value over the life of the phone by adding this back into our purchase price.

$496 + $149.61 = $645.61 break-even point.

For us to consider purchasing the old smartphone, we need to value it at $645.61 or more.  (Again, we are not even comparing with the new phone.) This is the minimum value we would put on this phone for it to be an option. If we cannot say that we would get at least $645.61 in value out of the old phone, our decision is over.  Do not buy it. 

Step 4: Make a Decision

What we calculated in Step 3 was our minimum values for how much we value each phone. Now we can calculate the difference in these values:

$1300.02 – $645.61 = $654.41

Now we can finally make our decision of which phone we want to buy. Do you think you will get $654.41 more in value from the new phone than from the old phone?

This is only up to you. Nobody can tell you how much you personally value either phone. The purpose of the 4-step process is not to tell you which choice is “best.” It is for you to see the full impact of your decision across time.

Once we factor in opportunity cost, amortization, and depreciation, the choice of phone looks a lot different. A $400 sticker price difference transforms into a $654.41 value difference once we look at how the purchase impacts us across time. This means a smart shopper will go for the older phone, unless they can justify to themselves why the new phone is worth $654.41 more.

If you want to try out this exercise for yourself, you can download a sample spreadsheet here showing the steps above.

Hold On, This Is Way Too Complicated!

Now that you have seen all 4 steps in action, you can understand the value of looking at a purchase over a longer period of time, but actually making all these complicated calculations when you are standing in a store considering two alternatives seems a bit unlikely.

And you are completely right!

It will be very rare when you compare two or more options using this full process. At most, you might sit down for the full calculation once or twice per year. The important thing is not that you calculate the exact realized purchase cost, amortized cost, and depreciated value, but that you remember all three of these factors should weigh into your purchase decision, not just the sticker value.

Calculate at the Check-Out

The next time you make a purchase for something you expect to keep for a long time, try thinking specifically about how long you expect it to last. Next, remember that the money you are spending is money you are not using for something else, like investing, so add in a bit of extra cost to account for what you are missing out on.

Now divide that full cost over its useful life, whether it is 6 months or 5 years. Every purchase you make has a useful lifespan.  Do not fall into the trap of thinking a purchase is good forever. Whatever the item is, it will break, a better alternative will enter the market and you will buy it, or the reason you originally bought the item will eventually disappear from your life. Always consider the maximum useful life of every purchase. This will at least give you some idea of how much this purchase will cost per week, month, or year of its life.

Finally, consider how fast the purchase will lose its value. A lot of technology loses its value fast.  Our cell phone example was decaying at about 30% per year. Better alternatives are always coming out and new apps are released that require newer hardware. Your clothes will also have a fast decay rate since they go out of fashion or are damaged through normal use. Other purchases, like kitchenware or furniture, will lose value more slowly.

You do not need to take out your calculator and get exact numbers for each step, but you do need to remember that all of these factors exist! Just keeping that in the back of your mind will make you a much smarter shopper and will help you see the true value and cost of your long-term purchases.

Get PersonalFinanceLab

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=128]

Challenge Questions

1. Using examples from your own life, explain what opportunity cost is.
2. Why should depreciation be a consideration when purchasing a product?
3. In the text above, what is meant by the real cost?
4. Explain what you understand by the term amortization and how would you explain it to someone else using an example?

Health insurance is usually the most complicated and expensive insurance you need. Unfortunately, it is also usually the most important, making it very difficult to avoid the cost.

With very few exceptions, health insurance is mandatory for all citizens in the United States, but the way you become insured will change drastically based on your age, income, and the company you work for.

Types of Health Insurance

Health insurance falls into three broad categories:

Public Insurance

Our government provides public insurance directly for some individuals. This includes Medicare, healthcare for the elderly, Medicaid, healthcare for low-income families and children, and some health insurance coverage for veterans. These public health programs are funded through payroll taxes, and the coverage provided is not free.  The covered persons usually must pay some amount out-of-pocket before the public insurance takes effect.

About 50% of all healthcare spending in the United States is through public insurance programs, the largest portion being through Medicare.

Group Insurance

Employers often offer group health insurance to their employees. With group health insurance, a business will split the cost of health insurance coverage with its employees. Eligible employees are usually required to participate in the program, unless they have better coverage from somewhere else. (Since a husband and wife may both have group health insurance options through their employers, the couple will decide which option is better and cheaper for the family.)  Group insurance is usually the cheapest option for individuals.  This is because it groups many people from different age groups and different risk levels together and splits the cost with the employer. Big group policies also have bargaining power to negotiate better deals with insurance providers. About 60% of Americans have health insurance coverage through their employer.

Individual Coverage

You may need to purchase health insurance directly from a health insurance provider yourself if you cannot get it through your employer. The cost of insurance you purchase as an individual is usually higher because you are not splitting the cost with your employer. There are some subsidies and state-run insurance exchanges that can make this cheaper. About 9% of Americans are covered through individual health care plans.

Health Insurance Terminologies

Health insurance is built upon the same core concepts of premiums and deductibles, like other forms of insurance. The premium is the monthly charge you pay to have health insurance coverage. The deductible is the amount you pay first for medical expenses before your insurance pays. As with all insurance policies, there is a balance between the premiums you pay, the deductibles you pay when there is a claim, and the level of coverage you receive.

Health insurance also has other concepts that you need to understand. 

Co-payments and Coinsurance

Co-payments and coinsurance refer to the amount of money you are responsible for paying, beyond your premium and deductibles. 

A co-payment is what you pay per visit to be seen by a health care provider.  There is no maximum to the amount of co-pays you would pay in a year.  For example, if your policy states that you have a $50 co-payment for a doctor’s visit, you will need to pay the first $50 out-of-pocket for each visit, with your insurance covering the rest of the cost.

Coinsurance requires you to pay a certain percentage of the cost for treatment.  For example, if your policy states a 10% coinsurance level, you would be required to pay 10% of any medical cost incurred.  Your insurance provider would cover the remaining 90%.

Coverage Limits and Maxima

Heath insurance policies may put a ceiling on how much in total they will pay for medical expenses in a year. Once that maximum amount is reached, you now pay out-of-pocket.

The coverage limit is the term referring to the total amount an insurance company will pay out for a single policy over the course of the year.  Sometimes, this applies to the maximum over your lifetime. Any additional expenses above this amount will be entirely passed on to the insured.

If your policy includes an out-of-pocket maximum,  that means there is a cap on the maximum amount of money that you would be required to pay yourself before the insurance covers everything else at 100%.  For certain policies, in order to keep premiums and deductibles low, the tradeoff may be a high coinsurance percentage.  These policies would most likely include an out-of-pocket maximum to ensure that individuals would not be bankrupted by very expensive medical emergencies.

Networks, Authorization, and Emergencies

You may have noticed that health insurance can be quite complex. Unfortunately, it gets a bit messier from here!

When health insurance companies keep their costs down, this means your coinsurance payments are lower. To keep costs lower, the insurance companies often make specific agreements with hospitals, doctors, and other healthcare providers to set standard costs for routine procedures. They also negotiate prices for more complex procedures. As the insured, you do not necessarily need to worry about these negotiations and specific contracts, but you do need to be aware of which doctors and hospitals your insurance provider has agreements with.

In-Network and Out-of-Network

In-Network healthcare providers are the providers that your insurance company has contracts and agreements with. If you visit an in-network doctor or hospital, your costs will be much lower. If you visit an out-of-network provider, your costs will usually be much higher, and your health insurance company may refuse to pay at all unless you can prove there was no viable in-network alternative. These agreements often apply to prescription medications as well.  Your health insurance may not cover all medications your doctor prescribes. You should always call your health insurance provider before visiting a specific health center to find out if they are an in-network provider.

Prior Authorization

For certain expensive tests and procedures, your insurance company may require that you get their authorization prior to setting an appointment.  This is usually done by getting an in-network doctor to confirm that the procedure or test is necessary. If your insurance provider refuses to authorize your care, you can appeal it to an independent third party to review your case.  It’s not that the insurance company doesn’t want you to have treatment. They just want to make sure that an in-network doctor truly believes it is necessary.

Emergency Care

Emergency Care is the exception to both your network and insurance pre-authorization requirements. If you are injured or very sick, you are entitled to use emergency services of almost any healthcare provider and your insurance will cover it.

Supplemental Health Insurance

Normal health insurance coverage does not cover many non-life-threatening health issues. Supplemental insurance policies exist to fill this gap.

Co-Insurance Supplement

If your insurance plan includes a high co-insurance percentage, you could end up spending thousands of dollars for an unexpected surgery and hospitalization.  In order to reduce that financial risk for you, some companies offer supplementary insurance plans.  Supplemental insurance provides an added layer of financial protection by covering the out-of-pocket expenses that your primary health insurance plan does not cover.  This can include the cost of copayments, coinsurance, and deductibles.  The policy coverage limit is normally set at the same level as your primary policy’s out-of-pocket maximum. This means that with both primary and supplemental insurance policies, your out-of-pocket costs could simply be the cost of your annual premiums. 

Vision and Dental Insurance

Most health insurance policies do not cover glasses, contacts, routine eye exams, or dental care.  You will need supplemental Vision and/or Dental Insurance Plans to cover these treatments and exams. Some vision and dental plans are designed to cover all costs at 100% after you pay the deductibles.  Others do not provide explicit coverage such as paying for the cost of an eye exam or a filling.  Instead they provide a list of “Network Providers” and the costs you will pay for specific treatments. These costs reflect a discounted price for Insured individuals. This works the same fashion as the provider network you get through your health insurance. Your dental or vision insurance provider negotiates with eye doctors and dentists to lower prices for the individuals covered through their insurance plans.

Specified Disease Coverage

Sometimes you are able to purchase insurance that explicitly covers one disease. For example, if your family has a history of breast cancer, it may be possible to get a specific breast cancer health insurance policy supplement.

These specific disease supplements generally emphasis preventative care and early testing. This helps catch the disease early which both improves survival rates and reduces total cost. Having specific disease coverage can reduce premiums on your primary insurance coverage. This is because it lowers the risk that your primary insurer will need to cover issues from that particular costly disease.

Why Health Insurance Is So Expensive?

For insurance companies, their ability to operate successfully comes from collecting more money in premiums and fees than they need to pay out in expenses. For individuals, they want to feel that the money they pay in premiums and fees will provide the coverage they need.  When balancing these two parties’ needs, determining the “right cost” is key.  How much to charge and how much to pay are questions that get re-evaluated on a regular basis.

Healthcare emergencies are often extremely expensive, and sometimes the needed care drags on for a very long time, accumulating hundreds of thousands of dollars in medical bills. This means even if your personal risk of having a medical emergency is fairly low, the potential cost for the insurance provider is extremely high. This is the main reason why health insurance policies are so expensive.  The company needs to plan for potential costs.  But there are a few other factors that contribute to rising costs as well.

The Self-Selection Problem

In the past, health insurance was not mandated for all citizens. Most people were insured through the companies they worked for or were covered by public insurance. Those who were not covered by these options could decide if they would purchase individual medical insurance or remain uninsured.  They could self-select to be insured or not.

Because medical insurance is so expensive, it meant that most of the people who enrolled on their own were people at high risk of having medical problems. This increased the likelihood that the insurance company would have to pay claims for a higher-risk individual, and this probability caused the rate of premiums to increase.  Preventing this “self-selection” problem is the main reason why health insurance is now mandatory in the U.S.  Having more low-risk individuals in the insurance pool should lower the average premium.

The Emergency Room Problem

In the United States, emergency rooms are required to treat every patient who arrives. Insured and uninsured individuals can get seen and treated there.  However, people may not know that getting treatment at the emergency room is by far the most expensive way to receive medical care.  Because ER doctors cannot turn anyone away, this means that an uninsured person with little savings and a chronic medical problem can use the emergency room to receive the treatment he needs. The emergency room provides the treatment, but who will pay the bill? 

The cost of providing medical care does not evaporate if the person is unable to pay the bill. Instead, the cost gets redistributed among all the other patients at a hospital who are able to pay. This means the cost of every other type of care at the hospital goes up. This is why you may have heard infamous stories such as the $15 hospital Tylenol or experienced extremely high costs for your own emergency room visit.  This financial dilemma causes a loop.  As the cost of other treatments goes up, more individuals who are uninsured find it difficult to pay their emergency room bills, pushing treatment costs  even higher.

Most people with insurance do not need to worry much about these costs.  Insurance companies usually negotiate directly with the hospitals to force these costs back down. The government pays for people with public insurance coverage, but they do not usually negotiate prices as much as private insurance companies do.

The Regulation Stability Problem

You may have heard about some of the major changes that have been discussed by Congress over the last couple of years regarding health care in the United States. Usually those discussions center around how much insurance will be subsidized, what levels of care are mandatory, and how many people might be covered by public insurance programs. For health insurance companies, all of these changes create problems to be addressed. For example, it makes it difficult to engage in long-term planning regarding premium costs for current customers when the government is enforcing changes in the industry.

When insurance regulations are being rewritten and reformed, the fee structure becomes unstable. Health insurance companies often raise their premiums to protect against big changes in their insurance pool, the group of people covered. For example, the government currently provides a subsidy to encourage insurance companies to cover more low-income families. If health insurance providers hear that Congress is considering removing the subsidy at some point in the next few years, it is probable that these low-income families could drop out of the insurance pool, raising the insurance company’s average cost. The insurance company would also lose revenue, since they would no longer be receiving the subsidy. To protect against this potential change in the future, they raise premiums slightly in the short term to act as a buffer.

Get PersonalFinanceLab

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=127]

Challenge Questions

1. In your opinion, is it worth having Health insurance?
2. Using examples, explain what a deductible is.
3. What is the opportunity cost when considering whether you should have Health insurance or not?
4. How do insurance companies calculate the premium they will charge people for their insurance policies?

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.

Get PersonalFinanceLab

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=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.

Get PersonalFinanceLab

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=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.

Get PersonalFinanceLab

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.

Get PersonalFinanceLab

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=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.

Get PersonalFinanceLab

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=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.

Get PersonalFinanceLab

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=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.

Get PersonalFinanceLab

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.

Get PersonalFinanceLab

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

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.

Get PersonalFinanceLab

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=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?