Though you can cancel PMI once you have 20% equity in your home (whether because home prices have increased or because you"ve made payments to the princ.i.p.al), lenders aren"t required to automatically cancel PMI until you"ve repaid 22% of the loan. That means you need to stay on top of things so you don"t keep paying for PMI any longer than you have to.
To find out whether you"re paying PMI, check your most recent mortgage statement. If you are, do whatever you can to cancel it as soon as possible. Make extra mortgage payments. If home values in your area have risen, have your house re-appraised. (But note that not all lenders will drop PMI based on a new appraisal; some require you to refinance.) When you have at least 20% equity in your house, contact your lender and ask to have the PMI removed. Doing so could save you thousands of dollars.
TipFor more on PMI, check out this article at OmniNerd.com: you prepay your mortgage?
You can save tens of thousands of dollars by paying your mortgage off early. But is it a smart move? You won"t find a definitive answer in this book or anywhere else. Ask a dozen different financial experts and you"ll get a dozen different answers-literally: wouldn"t you pay off your mortgage early? There are actually several sensible reasons you might choose to hang onto that debt: - If you prepay in good times, there"s no easy way to get that money back during bad times. The only way to "undo" prepayments is to take out a second mortgage.
- When you have a mortgage, inflation is your friend: In 30 years, your $2,000 monthly payment will seem like a $500 payment.
- No matter how much you prepay, the bank doesn"t give you a break-you still have to make payments each month until the mortgage is completely paid off, even if you get sick or lose your job.
- There"s an opportunity cost to prepaying your mortgage: When you send in an extra payment, you can"t use that money elsewhere-such as investing in the stock market, which might give you a better return.
Despite these compelling arguments, millions of Americans prepay their mortgages. Their reasons make sense, too: - Prepaying gives you a guaranteed return on your investment equal to whatever your mortgage rate is. That"s because any time you pay down debt, you earn a return equal to the interest rate you"re being charged. So if your home loan has a 6% interest rate, then paying extra on that debt is like earning 6% in a savings account. You"d be hard-pressed to find other places to earn a guaranteed 6% return!
- Prepaying gives you a safety net. While you"ll still have a mortgage payment until you"ve paid off the loan, when you do pay it off, you"ll have a huge cushion because your monthly expenses will drop by $1,000, $2,000, or even $3,000. Just think of what you could do with that cash flow!
- People who"ve paid off their homes feel a huge sense of relief (see It"s freeing to not have a mortgage holding you down.
Few people would argue that prepaying your mortgage is a bad move, but there are some who don"t think it"s the best move. Is prepayment right for you? If you plan to stay in your home for a long time, it may be. The choice depends on your financial goals and what will make you happy.
NoteWhen should you refinance your mortgage? When you can recover the costs in a reasonable amount of time, typically just a few years. The standard advice used to be to consider refinancing if interest rates dropped by 2%. But closing costs are lower now, and it often makes sense to refinance sooner. You"ll need to run the numbers based on your own situation using a refinance calculator like the one here: for prepaying your mortgage If you"ve weighted the pros and cons of prepaying your mortgage and decide to go for it, there are several ways to approach it. You could: - Make extra payments to your mortgage each month. This will give you a guaranteed rate of return equal to your mortgage interest rate, and will reduce the amount of interest you pay over the life of the loan. But doing this makes it difficult to get at your money if you need it for something else.
- Make lump-sum payments to your mortgage every year. Instead of paying a little bit every month, you could put the money in a savings account during the year and make a single, large payment every 12 months.NoteWhenever you pay extra money toward your mortgage-or any other loan, for that matter-always note that you want the extra applied to princ.i.p.al only, not interest. (Check with your mortgage company to find out exactly how they"d like you to indicate this.) If you don"t, some lenders will apply your extra payment to interest, which is lame but legal.
- Send half the monthly amount every 2 weeks. This is perhaps the most common way to accelerate mortgage payments. If your monthly minimum payment is $2,000, for example, you"d send $1,000 every other week. By doing this, you"d pay $26,000 a year instead of $24,000. That may not sound like much of a difference, but this strategy could trim 7 years off your loan! (Use this calculator to see how much you could save: you decide on this strategy, check with your lender to see how they handle bi-weekly payments. Some aren"t set up to process them, so you might have to enroll in some sort of program. Search for a free program rather than a paid one-but take the paid program if that"s all that"s available.
- Put money into some other investment, like an indexed mutual fund (which you"ll learn about in Chapter12 Chapter12) until you have enough to pay off your mortgage. This will, in theory, provide the highest rate of return for your money. But as with any stock-market investment, there"s an element of risk. If your goal is to pay off your mortgage, a bear market (like the one in 2008) will make you sweat.
You can accelerate your mortgage payment in other ways. My wife and I chose to make a flat $2,000 monthly payment, which was $582.10 more than the minimum payment. This gave us flexibility-if we had an emergency we could drop down to a regular payment. You can read more about our plan here: you decide to accelerate your mortgage payments, try to do it on your own. Banks often charge a fee to add this as a service, but you can usually do it yourself for free.
Chapter11.Death and Taxes.
"In this world nothing can be said to be certain, except death and taxes."-Benjamin Franklin Taxes and insurance are topics so dull that even the keenest reader feels her eyes glaze over. But they"re important-very important. With a basic understanding of taxes and insurance, you can make better decisions about other parts of your financial life and avoid costly mistakes.
This chapter won"t give you all the answers-for that you should consult a professional financial adviser. But it will give you the basic info you need to deal with taxes and insurance effectively. It also provides a very brief overview of estate planning. Ignore this info at your peril!
An Introduction to Insurance Insurance is a way to manage risk. As you go about your life, there"s always a chance that you"ll be in a car accident, twist your knee, or that your house will burn down. The risk of these accidents is small, but if one of them were to happen, the effects could be catastrophic. Without insurance, you"d have to come up with the money on your own to repair your car, have knee surgery, or rebuild your home.
Although these things happen to some people, they don"t happen to everyone. With enough data, it"s possible to know roughly how many people are likely to experience these events-and how much recovering from them will cost. Using this info, an insurance company can spread the risk among all its customers.
Here"s an example: Imagine a school with 100 students. Every year for the past 25 years, one student has broken an arm in the schoolyard, resulting in about $5,000 in medical expenses. Without insurance, every family would have to save $5,000 to cope with the odds that their child would be the one with the broken arm. At the end of the year, 99 families would have paid nothing (and have $5,000 in savings), but one family would have paid $5,000 (and have nothing left).
With insurance, the families could join together to spread out the risk. If they created an insurance fund, all 100 families would pay $50 at the start of the school year. This $5,000 would then go to the family of the child with the broken arm.
By spreading the risk, each family only has to save $50 instead of $5,000. Yes, that $50 is gone if it"s not your child who breaks an arm, but for most people, that"s an acceptable trade. Instead of having to sc.r.a.pe together the full $5,000, they"d rather risk losing $50 for a chance to avoid $5,000 in medical bills.
But is it really fair to have every family pay $50 into the insurance fund? Some kids go to the library at lunch and read books while their cla.s.smates are climbing around on the jungle gym. The bookworms are much less likely to break an arm. And maybe the 25 years of data show that girls break their arms less often than boys. With enough info, the playground insurance fund could charge each family a different rate depending on how likely their child is to break an arm.
Insurance is a bit like gambling: You"re betting a little money now because you think odds are good that you"ll need a larger payout in the future. But there"s one huge difference between gambling and insurance: Gamblers seek risk in an attempt to get more money; when you buy insurance, your goal is to reduce risk so you don"t lose money.
In fact, gambling casinos and insurance companies make use of the same statistical laws, especially the Law of Large Numbers, which says that the more you have of something, the more likely the characteristics of that something will tend toward average. The more people who roll the dice, for instance, the better the casino can predict its earnings. And the more people in an insurance fund, the more accurately the insurance company can predict its losses.
Most of the time, using insurance to spread risk is a good thing. That"s why most states require car insurance, and why smart folks keep homeowners insurance even after their mortgage is paid off. But insurance can be expensive, especially if you have too much or the wrong kinds. Let"s look at some ways to keep your insurance costs down.
NoteWikipedia has a great article about insurance and how it works: The history section is especially interesting.
General Insurance Tips All insurance works pretty much the same way: You pay a premium (a set amount of money) to the insurance company, usually on some sort of schedule (monthly or yearly, for instance). In return, they issue you a policy, which is a contract that gives you certain coverage, or financial protection. When you suffer an insured loss, you file a claim and the company pays you a benefit.
Insurance is meant to protect against catastrophes, not day-to-day annoyances. You use insurance to protect yourself from things that aren"t likely, but which would cause financial hardship if they did happen.
Your goal should be to have just the right amount of insurance. If you have too much, you"re wasting money. For example, if you have a $50 deductible on your car insurance, you"ll probably end up paying the insurance company more in monthly premiums than they"ll ever pay you in benefits. (The following list explains deductibles.) Or if you"re young, unmarried, and have tons of credit-card debt, life insurance usually isn"t a good place to put your money.
On the other hand, if you"re a 40-year-old small-business owner and father of three, life insurance could be an excellent way to hedge against the risk that you"ll die tomorrow. Or if you"re a millionaire who likes to drive fast, increasing the limits on your automobile liability coverage could save your fortune if you get sued for damage you cause.
The number one thing you can do to save on insurance is to self-insure as much as you can afford (see box on General Insurance Tips General Insurance Tips). You can also save by reviewing your coverage from time to time, and following these suggestions: - Shop around. To find better rates, harness the power of the Web. Visit the National a.s.sociation of Insurance Commissioners (www.naic.org) and click the "states and jurisdictions" link to find your state"s insurance department. From there, you can find info about your state"s insurance laws and, in some cases, get quotes. You can also get quotes from multiple insurance carriers at sites like Insweb.com, Insurance.com, and Insure.com.
- Buy only what you need. Insurance agents are happy to sell you more coverage than your situation calls for. So do some research before you buy. Figure out how much and what kind of insurance you need, and don"t let the agent talk you into more.
- Raise your deductible. The deductible is the amount you pay on a loss before the insurance company kicks in money. For instance, if your car suffers $400 in damage and you have a $250 deductible, you pay the first $250 and your insurance company pays the rest. It"s up to you where to set the deductible, but the lower your deductible, the higher your monthly premiums. Ask yourself how much you can afford to pay if something goes wrong; more specifically, how much is too much? Set your deductible just below "too much."
- Consolidate. Insurance companies often give a discount if you have multiple policies with them. Plus, this saves you the ha.s.sle of having to pay more than one company.
- Read your policy. As with all legal contracts, it"s important that you read your policy so you know what"s covered and what isn"t. Pay attention to policy changes that come in the mail. If you have questions, ask. And make it a habit to review your policies every so often to be sure you understand them (and to check whether anything has changed).
- Don"t duplicate coverage. Know which policies provide which benefits. If you have a AAA membership, for example, you don"t need towing insurance on your auto policy. And if your credit card doubles the warranties on the things you buy, don"t pay for extended warranties.
- File fewer claims. Don"t nickel-and-dime your insurance company. If you file claims for every little thing, they"ll raise your rates. Insurance is meant to cover unexpected big losses, not every ding your car gets from shopping carts.TipTo increase the odds of a satisfactory settlement when you file a claim, be sure to doc.u.ment your losses well. And it"s perfectly acceptable-good even!-to negotiate if you think the insurance company"s settlement offer isn"t fair (and their first offer almost never is). Be persistent.
- Take care of the things you insure. One of the best forms of insurance is routine maintenance. A well-maintained car is less likely to have an accident due to mechanical failure. If you take care of your house, it"ll weather the ravages of time. And if you exercise and eat right, you"ll get cheaper life and health insurance.
These tips can help you save on most types of insurance. Still, not all insurance advice can be generalized; each type of insurance has its quirks. Let"s look at specific ways to save on three common types of insurance: auto, home, and life.
Your Money And Your Life: The Best Insurance Is Self-InsuranceWarranties are a form of insurance: When something is under a warranty, the store or company you bought it from will fix or replace the item if it breaks or malfunctions during a specific period of time.Warranties may seem like a good deal, but according to the Washington Post Washington Post ( ( Americans paid $15 billion for warranties in 2004. Of every $100 spent on extended warranties, only $20 was paid out in claims. So when you buy an extended warranty, you"re basically throwing away 80% of your money.Fortunately, there"s a better way to protect yourself-and lower your overall insurance costs: Instead of paying somebody else to insure your new TV, computer, or digital camera, pay yourself! Open a named savings account (see Targeted Savings Accounts Targeted Savings Accounts) and call it something like Personal Insurance. Then funnel money into the account whenever you find a way to save on insurance elsewhere.For example, use self-insurance to replace service contracts and extended warranties. Take the amount you would have paid the store and put it into this savings account instead. The best part of this plan is that if you don"t end up needing the money you"ve set away for self-insurance to fix stuff, you can use it for other things; if you"d paid for an extended warranty, that money would be long gone.Self-insurance isn"t just a good strategy for appliances. Try raising the deductibles on your auto and home insurance policies. Then take the difference between your old premiums and your new premiums and put it into your self-insurance account every month. It won"t take long for you to have more than enough to cover the deductible.It"s worth paying for insurance to protect against life"s catastrophes. But for smaller stuff like appliances and minor car accidents, self-insurance is usually the way to go.
Car Insurance You"ve had car insurance since you were old enough to drive, but how much do you really know about it? At its heart, your policy probably contains a few basic types of coverage: - In most states, you at least need to have liability insurance, which covers the cost of any damage you do to other people or things with your car. (But note that liability insurance doesn"t cover injuries to you or other people on your policy; for that, you need PIP insurance, which we"ll cover in a moment.)Insurance companies quote liability coverage as a series of three numbers, like 50/200/25. The first number is how much, in thousands of dollars, the policy will pay for each person (besides you) injured in an accident ($50,000 in this example). The second number is the total that the policy covers for each accident ($200,000 here). And the last number tells how much property damage will be reimbursed ($25,000 in this case).TipMany experts recommend carrying liability coverage equal to your net worth-the total value of everything you own. This can be expensive to do on individual policies. Instead, it may be more cost effective to buy an umbrella policy, which gives you extra liability coverage above what your home and auto policies provide.
- Collision insurance, as you can probably guess, covers damage to your car when it hits (or gets. .h.i.t by) another vehicle or object. But because collisions aren"t the only way your car can get banged up, comprehensive insurance covers damage from events other than collisions: floods, fire, theft, and so on. Collision and comprehensive coverage make more sense for newer vehicles, and are generally required if you"re still making payments on your car. They"re less necessary-and may actually be a waste of money-on older cars.
- Personal injury protection (PIP) insurance is sometimes called "no-fault" insurance, and is required in certain states. It covers medical costs (and possibly lost wages) if you"re injured in an accident. It may also cover pa.s.sengers and pedestrians.
- Uninsured motorist insurance covers you and your pa.s.sengers if you"re in an accident caused by a driver who doesn"t have insurance. It also covers. .h.i.t-and-run accidents.
TipFor more on the different types of auto insurance coverage, check out this handy page of definitions: year, you spend hundreds-maybe even thousands-on car insurance, and chances are, you"re paying too much. The August 2008 issue of Consumer Reports estimated that the average family could save $65 per month by shopping around for car insurance. Here are some other ways to lower your costs: - Ditch towing coverage. Towing-or "emergency roadside service," as it"s sometimes called-is an easy cost to self-insure (see General Insurance Tips General Insurance Tips). You likely pay $10$30 a year for towing insurance, and one tow costs $100. (If you"re in an accident, towing is usually covered under collision, but check with your insurance company to be sure.) Sometimes your car will break down, but if it"s well maintained, that won"t happen often.TipIf the value of your car has dropped so low that a major repair would cost the same as replacing it, consider dropping your comprehensive and collision coverage. Then use your savings on premiums to boost your self-insurance fund (see General Insurance Tips General Insurance Tips).
- Plan ahead. Check on insurance before you buy your next car. Insurance costs are based on how likely a vehicle is to be stolen, damaged, or to inflict damage, and how badly occupants tend to get injured in accidents. Repair and replacement costs are also factors. Many insurance companies list cars with lower insurance costs on their websites.
- Watch your credit. As mentioned in Chapter8 Chapter8, most insurance companies now look at parts of your credit report to determine your premiums. They can"t adjust rates on your current car if you pay on time and in full, but anytime you add a new vehicle, its premiums are affected by your credit.TipIf your credit has improved since you bought your car, ask your insurance company to re-check your credit score and see if they"ll lower your premium.
- Don"t pay monthly. Insurance companies charge a few bucks each month for monthly billing. To avoid that fee, pay every 6 months or even once a year, if possible. If you have to pay monthly, use their autopay program, which costs less because they don"t have to send you a paper bill unless your premium changes.
Though it"ll always cost more to insure a new Corvette than a Corolla, one of the best ways to keep costs low is to keep your driving record clean. Insurance companies charge you based on how likely you are to file a claim-and accidents are the biggest source of claims. Some insurance companies offer discounts for taking safe-driving courses. Others give low-mileage discounts-the less you"re on the road, the safer you are. So be sure to ask about all the discounts you qualify for.
Homeowners Insurance Your home is probably the most valuable thing you own. Plus, it"s filled with all of your Stuff. If your house burned down or got burgled, that would certainly qualify as a financial catastrophe-which is exactly what insurance is designed to avert. It"s impossible to give a specific figure since everyone"s situation is different, but you should carry enough insurance on your home to protect you in case of just such a disaster.
Homeowners insurance policies have three main parts: - Dwelling coverage insures your home in case it"s damaged or destroyed. You want a guaranteed replacement cost policy, which requires the insurance company to fully rebuild your home. (Other policy types may not offer enough coverage.) But you don"t need a policy that covers the full resale value of your property, since that includes your land, which doesn"t need to be insured.
- Personal property coverage insures the Stuff inside your house, like clothes and furniture, and usually also insures the personal property you have with you while you"re away from home. Your insurance can be for either actual cash value (how much your things are currently worth) or replacement cost (how much it would cost to buy them new). The latter is your best bet: You should carry insurance that would pay you to replace your belongings, not pay you based on what the insurance company thinks they"re worth.TipTo help settle claims in case of a disaster, keep a record of the things you own (including receipts for expensive items). Use your digital camera to create a photo (or video) inventory of your Stuff, and keep a written record somewhere safe or use an online tool like KnowYourStuff.org or StuffSafe.com.Some people buy floater policies to cover things like jewelry and antiques. Before doing this, check your personal property coverage-you may already have enough insurance to cover these kinds of items. (In order to be covered, your policy may require you to notify your insurance company if you have over a certain amount.) - Liability coverage protects you if somebody is hurt on your property and sues you. Most policies cover you off your property, as well. You should have at least as much coverage as your net worth, and some experts say you should have twice your net worth. If someone trips on your doorstep and breaks his collarbone, say, he just might follow through on his threat to sue you for everything you own.
Most homeowners policies contain other pieces, like insurance for loss of use (which covers you if you have to live elsewhere while your home is being repaired). It"s important to review your policy every year or so to be sure you have the right amount of coverage. (If you want disaster insurance for earthquakes, floods, or hurricanes, you"ll have to ask your insurance agent how to get it; it"s usually not part of a standard homeowners policy.) To lower the cost of homeowners insurance, follow the general insurance tips on General Insurance Tips General Insurance Tips, and take steps to reduce the risk of fire and theft: Keep fire extinguishers in your home, install modern smoke detectors, and even consider adding an automatic sprinkler system. Put deadbolts on the doors, and, if you can afford it, install a burglar alarm. If you have an older home, modernize your electrical and plumbing systems. Once you"ve made safety improvements, contact your insurance company and ask them to review your policy.
TipFor more money-saving ideas, check out this advice from the Insurance Information Inst.i.tute: Insurance In Chapter6 Chapter6, you learned that your job is your second most important financial a.s.set right after your health. Your income provides food and shelter for your family, and helps fund future plans. But what would happen to your family financially if you died? If the loss of your income would be a catastrophe for them, you need life insurance.
TipLife-insurance premiums have fallen dramatically over the past decade. If you bought a policy during the 1990s, it"s worth checking prices again today. The August 2008 issue of Consumer Reports found the average person could save over $100 per month by "refinancing" their life insurance-buying a new, cheaper policy. If you do find cheaper insurance, don"t cancel your existing policy until the new one is in place.
The two basic types of life insurance are: - Term insurance, which gives you coverage for a set period of time (the term), like 5 years, 25 years, or whatever (you can choose from different terms). As with car or home insurance, you decide how much coverage you want (more on that in a minute), and then pay an annual premium. Unless you buy level term insurance, your premiums start out small and get higher as time pa.s.ses. If you die during the term, the policy"s beneficiaries (usually your family) receive an income-tax-free payout.
- Cash-value insurance (officially called permanent insurance), which is similar to term insurance but lasts your entire life, not just for a fixed term. Common types of cash-value insurance include whole life, variable life, and universal life. Each of these adds an investment component to the policy that acc.u.mulates a cash value, which you can borrow against, reclaim if you cancel the policy, or eventually use to pay premiums.
Cash-value insurance sounds like a better deal, right? It lasts your whole life instead of just for a few years, and the insurance company invests some of your premiums so you can use them later. Not so fast. When you purchase permanent insurance, you"re most likely committing an insurance sin: buying coverage you don"t need. Term life insurance is usually the best choice for a number of reasons.
First, most people don"t actually need permanent life insurance. Your need for life insurance tends to fade as you grow older and your family is no longer dependant on your income. So if you take out a permanent policy, you may be paying for life insurance when you no longer need it.
Second, the investment part of a cash-value policy isn"t usually a good deal. After all, you don"t buy a savings account with your auto insurance policy, so why would you do so with your life insurance? Keep your insurance and investments separate. If you want to invest, there are better ways to do it. (See Chapters Chapter12 Chapter12 and and Chapter13 Chapter13 for investing info.) Don"t buy life insurance as an investment. for investing info.) Don"t buy life insurance as an investment.
Lastly and most importantly, cash-value insurance is much more expensive than term-five to 20 times more expensive! You could probably buy 30 years" worth of term coverage (which is all you really need) for the same cost as buying 5 years" of a cash-value policy.
TipFor $75, the Consumer Federation of America ( will evaluate a cash-value policy-one you already own or one you"re thinking about buying-to find the "true" investment returns. This fee may seem high, but it"s cheaper than paying for insurance you don"t need.
That said, cash-value policies do make sense for some people. If you have a high income, will leave behind a multi-million-dollar estate, or own a small business, cash-value insurance might be worth a look-if you think you"ll have it for 20 years or more. Whatever you do, don"t ask an insurance salesman for advice; of course he"ll tell you to buy it. Instead, find an independent financial adviser and ask her about your options.
The bottom line: For most people, the best choice is guaranteed renewable term life insurance. (Guaranteed renewable means that as long as you keep paying your premiums, the insurance company can"t cancel your policy.) TipAny time you make a major life change like getting married or divorced, don"t forget to change the beneficiary on important legal doc.u.ments like your life insurance policy, retirement accounts, and will.
How much life insurance do you need?
Not everyone needs life insurance. Like all insurance, it"s designed to prevent financial catastrophes. So you only need it if other people-like your spouse and children-depend on your income. You need it less when you"re older because your kids will be on their own and you won"t have any debts (presumably, anyway).
Specifically, life insurance is valuable if you have kids living at home; have a spouse whose income alone couldn"t support your family"s lifestyle; have large debts (like a mortgage); are wealthy and might be subject to estate taxes; or own a business. If any of these describe your situation, then life insurance is a good idea. If none of them apply to you, then you don"t really need it.
How much life insurance should you buy? Different experts give different answers. Some say your policy should cover five times your annual income, others say 10. And in The Money Book for the Young, Fabulous & Broke, Suze Orman recommends 20 times your annual income. The truth is there"s no hard-and-fast rule.
TipFor a little help coming up with a coverage amount, use this handy online calculator from the nonprofit LIFE Foundation: than base your life insurance coverage on your income, it makes more sense to base it on what your survivors will need to pay their expenses. Think about why you want the insurance in the first place: Is it to pay off the mortgage? To fund your spouse"s retirement? To send the kids to college? Then get enough insurance to do that. You can comparison shop for insurance at sites like AccuQuote.com, DirectInsuranceServices.com, and SelectQuote.com.
NoteA brief word about disability insurance: You"re far more likely to become disabled than to die prematurely, and the loss of income is just as real. Even if you"re smart and pay yourself first by saving 10% of your income (see Get in the game Get in the game), just 6 months" of unemployment can wipe out 5 years" of saving. So if you need your salary to live on, you should get disability insurance. This topic is beyond the scope of this book, but you can learn about choosing and buying disability insurance at You Need to Know About Taxes There"s no way to cover the complexity that is U.S. tax law in just a few pages, and it would be foolish to try. Your accountant has spent years working with the tax code, and even she needs to use reference books. Instead, this section describes the basics of how income tax works and gives you some useful info on how to make smart tax moves.
How Income Tax Works The basic federal income tax structure is pretty simple, but there are layers and layers of laws that make it complicated. At its core, the tax system involves the following steps: 1. At the end of the year, you tally your total income from taxable sources. (Some income, like that from child support, isn"t taxable.) 2. You subtract certain allowable sums known as adjustments-like IRA contributions and moving expenses-to find your adjusted gross income, or AGI. (Your AGI, which is shown on line 37 of tax Form 1040, is a key number, and comes up again and again in tax discussions.)TipThe front page of Form 1040 lists adjustments; you can read more about them at www.irs.gov/taxtopics/tc450.html.From your AGI, you subtract deductions (allowances for living expenses) and exemptions (deductions for you and your dependents) to find your taxable income. (The back page of Form 1040 lists deductions and exemptions.) You can claim either the standard deduction (a single number that increases every year to account for inflation-see www.irs.gov/taxtopics/tc551.html) or individual itemized deductions (like mortgage interest and charitable contributions-see www.irs.gov/taxtopics/tc500.html).
3. After you calculate your taxable income, you check to see how much tax you"re liable for (the box on Know what you owe Know what you owe explains how tax rates work). explains how tax rates work).
4. You can reduce your tax liability through certain tax credits, which you qualify for by doing things like adopting a child or buying your first home. (The government usually gives tax credits for actions it wants to encourage.) 5. The final step is to calculate how much you owe, if any. Because you pay taxes throughout the year (through paycheck withholding, for instance), you have to subtract what you"ve already paid from your tax liability. If you"ve paid more than your liability, you get a refund; if not, you owe the difference.
When you get hired for a job, you fill out a Form W-4, which tells your employer how much tax to withhold from your paychecks. In theory, the money withheld should be enough to cover your income-tax liability, but this isn"t always the case.
Maybe you made a mistake on your W-4 or have other sources of income (like a side business or a capital gain from selling stocks). Or say you got a big bonus in one paycheck and your company withheld too much. Whatever the case, it"s unlikely that, at the end of the year, you"ll find that your employer took out exactly the right amount of taxes. If you paid too much, the government owes you a refund. If you paid too little, you owe the government the difference between what you should have paid and what you"ve already paid.
n.o.body likes to pay taxes, and some people get upset when they find they have taxes due. But your tax bill shouldn"t come as a surprise-you can (and should) keep track of your tax liability throughout the year. If you"re blindsided by a big tax bill at the end of the year, it"s because you didn"t think ahead. Advance planning is the best way to avoid such tax trauma.
Tax-Tr.i.m.m.i.n.g Tips You don"t have to like taxes, but you do have to pay them. Fortunately, there are a few ways to legally trim your tax bill. One is to take all the deductions (How Income Tax Works) you"re ent.i.tled to. The following sections explain other ways to pay Uncle Sam a little less.
TipThe best way to arm yourself for dealing with taxes is to get educated. That doesn"t mean you have to become a tax professional, but try to get a basic understanding of tax laws. Go to the library and borrow a book on preparing your own taxes, and spend a couple of hours reading it. This may be boring, but it"ll pay off in the long run.
Know what you owe To many people, taxes are a sort of black box: They don"t know how taxes are calculated, so they have too much or too little withheld from their paychecks. Having too much withheld usually isn"t a problem-it just means you get a big refund. But people can get awfully get upset when they owe more than they were expecting at the end of the year; they feel like the government is doing something sneaky and is tricking them out of their money.
You don"t need to be surprised by what you owe come tax time. Most of the tax info is available at the start of the year-you just have to find it.
For instance, it"s worth taking a little time to look at your tax situation at the beginning of the year so you can get your withholding amount right. To figure out how much your employer should withhold from each paycheck, you can use an online calculator like those at or or If you discover that your employer is withholding too much or too little, file a revised Form W-4 to adjust the amount.
TipYou can download great, free income-tax planning spreadsheets from www.taxvisor.com/taxes (scroll to the bottom for download links), which help you estimate out how much you"ll owe in taxes so you"re not surprised at the end of the year. (scroll to the bottom for download links), which help you estimate out how much you"ll owe in taxes so you"re not surprised at the end of the year.On The Money: Marginal Tax RatesNot all of your income is taxed the same; as you earn more, you pay more taxes. Your marginal tax rate marginal tax rate is what you"re taxed on the last dollar you earned. Confused? Here"s a concrete example. is what you"re taxed on the last dollar you earned. Confused? Here"s a concrete example.For the 2009 tax year, these were the tax rates for single filers making up to $171,550: Taxable Income 2009 Tax Rates Up to $8,350 10%.
$8,351$33,950 15%.
$33,951$82,250 25%.
$82,251$171,550 28%.