It's Not Fun, but It Has to be Done Benjamin Franklin wrote a 1789 letter that states, “But in this world nothing can be said to be certain, except death and taxes.” Even at the United States’ early beginnings, federal taxes were a necessary evil to fund various public projects and administrative costs. Today, federal taxes serve much of the same purpose. While virtually no one likes to prepare and file their taxes, it is a necessity if you want to avoid fines and further hassle. It is no secret that preparing and filing your taxes is notoriously complicated. Many people lament that it should not be so difficult to pay the government. However, some of the complications allow people to save money if they discover specific tax benefits. Knowing how to file your own taxes may be a good option if your tax situation is relatively straightforward, or if you are willing to learn the process. Why Do You Need to File Your Taxes Every Year? The short answer is that federal law requires that most individuals file taxes annually. Income taxes are assessed every year based on your income earned during that period. You then pay a percentage of that income to the government, less any deductions, adjustments, or credits that you qualify to receive. If you do not file (and pay) your taxes, then you may be assessed penalties and interest. The Internal Revenue Service (IRS) can even go as far as garnishing your wages and repossessing your property if you do not file and pay as required. The Benefits of Filing Your Own Taxes If you are one of the 43% of Americans that are doing your own taxes, you are certainly not alone. Roughly 53 million people prepared and filed their own taxes in 2018. There are many benefits to filing your own taxes, including: Saving money: Hiring a tax professional is expensive, and many people can prepare and file their returns on their own, completely free of charge. Control: Some people like knowing the exact information that is included in their return and being able to control the data, and for some, knowing precisely how the numbers work out, is comforting. Gain helpful information: When you prepare your taxes, you can see what items saved you money this year or which issues you should address so you can save money next year. While filing your own taxes is complicated, it can be beneficial under the right circumstances. There are several programs online that walk you through the process to help ensure you are taking advantage of all of your available deductions and credits. The Drawbacks of Filing Your Own Taxes In addition to the benefits, there are also some disadvantages to filing your own taxes. These include: Time and effort: Preparing and filing your taxes takes time and work You have to sift through financial information and deal with concepts that you may not understand well. The process can be frustrating and take a considerable amount of time. Error risk: If you do not completely understand how your taxes work, you run the risk of making a mistake because of misconceptions. If that happens, it could lead to underpayment and audits down the road. Questions: Even if you use a tax preparation software, you may still have questions that will remain unanswered unless you do significant research or reach out to a tax professional. For some people, the risk of having a substantial error that triggers the IRS’s attention is enough to scare them away from preparing their own taxes. Preparing for Filing Your Taxes When you begin work on your taxes, you should have information gathered throughout the year. Some of the most common items that you will need include: Social Security numbers for you, your spouse, and any dependents Information about wages, such as W2s or 1099s Investment income information Documents that represent any other source of income Information regarding adjustments to income, such as student loan interest paid, IRA contributions, and health savings account contributions, just to name a few Information regarding potential credits, including, for example, child care expenses, education expenses, or retirement savings contributions Data about any tax payments that you may have made throughout the year Keeping good records will help make tax preparation easier at the beginning of the year. [youmaylike] The Basics About What You Can Claim When Filing You must pay income taxes on all your income earned throughout the year. However, that income is reduced by a few things. The further you can reduce your taxable income, the less you tax you will pay. There are three general categories of tax reduction methods: Standard or Itemized Deductions Everyone can claim either the standard or itemized deductions. Standard deductions are a set amount that is based on your filing status. Itemized deductions are based on actual expenses that you incurred throughout the year. You can choose to use the higher deduction. The higher the deduction, the less tax you will have to pay on your income because your income decreases on paper. Itemized deductions include things like medical expenses, state and local tax payments, and home mortgage interest deductions. Itemized deductions will only decrease your income by a certain percentage, or up to a specific point. Adjustments Some adjustments to your income may also be available. These include things like paying student loan interest or alimony. Adjustments are more valuable compared to deductions because they decrease your income dollar for dollar. Credits A credit decreases your taxable income as well. Some credits are refundable while others are not. For example, you get a child tax credit simply for having children that qualify for that credit, but that credit will not be paid out to you if you do not have any tax obligations. On the other hand, the Earned Income Credit, which is available for low-income filers, will be refunded to you even if you do not owe any taxes. There are a wide variety of deductions and credits available. Take a look at the federal forms and related schedules to determine whether you might qualify for any of these. How to File Your Own Taxes If You Live Overseas If you earned income in the United States as a U.S. citizen or resident alien, you likely need to pay taxes on that income. This is true even if you live overseas. You can still choose to e-file or mail your tax return to the IRS once you have it prepared, just as if you physically lived in the United States. In some cases, you will be taxed on the income that you earned throughout the world. However, you may be able to deduct a portion or all of the revenue that was not made in the United States in some circumstances. Filing Online The IRS offers an online filing option that is free for individuals that have an adjusted gross income below a specific threshold. Generally, your income must be below $66,000 to qualify for this service. You can also file online by using a commercial tax preparation software. Examples of this type of software include: H&R Block TurboTax TaxCut TaxSlayer There are many programs available that will file your taxes for you, often for a fee. Knowing how to file your own taxes can be a great way to save money, but it can be tricky as well. If you want to file your taxes yourself, be sure to read the form instructions thoroughly and get familiar with various tax saving opportunities before you begin preparing your return.
Should You Focus More on Saving or Investing?
At their core, the practices of saving and investing are essentially the same. Both are methods of tucking away funds for your future, ideally after allowing that money to sit and grow in whichever account it’s held.
If you look below the surface, though, you see that there are some very key differences between saving and investing.
What Is Saving?
To save money is to store is somewhere safe, to prevent it from being spent or wasted over time.
There are many intended purposes for your savings. In fact, it’s actually recommended that you have more than one form of savings and even multiple account types.
Savings accounts can be both short-term and long-term. For instance, you might be saving for the down payment on your next new car, which you don’t plan to buy for a couple of years. At the same time, you may also have an emergency fund that is easily accessible, in case something comes up next week, next month or next year.
There are many ways to save your money, too, which don’t fall into the realm of “investing.” The most common is probably your everyday savings account. Offered by brick-and-mortar and online banks alike, savings accounts provide you with a safe place to store funds until they are needed. Plus, by keeping this money out of your checking account, you remove some of the temptation to spend it.
You could also choose savings vehicles such as certificates of deposit (CDs), money market accounts, treasury bills and bonds.
The level of growth that you’ll recognize from your savings depends on the account type and establishment that you choose.
Typically, you’ll find much higher interest rates offered by online banks than by brick-and-mortar institutions. Some banks will offer both traditional savings accounts and high-yield savings; as you’d probably expect, the latter will result in a higher return. Some may additionally offer money market accounts (MMAs), which typically have rates that compare to — or exceed — those offered by high-yield savings.
If you’re alright with locking your money away for a longer period of time, CDs can be a great option. In exchange for agreeing not to touch your money for a specified timeframe, banks will give you an even higher return on the funds.
While CDs are usually your best bet for maximizing interest earned, there is one important thing to remember: the liquidity of your funds.
Savings accounts are excellent for funds that you may need to pull from at a moment’s notice. If your car breaks down unexpectedly tomorrow, you’ll want to be able to access the cash required for a repair; being able to immediately withdraw from savings is important.
This makes savings accounts and MMAs the right choice for your liquid funds — or easily accessible savings that can be quickly converted to cash.
What Is Investing?
By definition, investing is the practice of saving in growth-optimized vehicles with the expectation of growth from your savings. Essentially, you expect that money to be profitable (or generate an income) over time.
Investments can be anything from stocks and bonds to mutual funds, index funds, ETFs, options, cryptocurrency and more. You can also invest in tangible items, such as real estate or gold.
You can utilize investments as a way of saving for the future (such as retirement or education savings) or generate a profit to increase cash flow.
On average, investments will see greater growth than your typical savings vehicles. The actual level of growth, however, depends on many factors: the economy, time, the nature of the investment and even your risk tolerance.
There is a direct correlation between risk and growth: the higher the risk you’re willing to take on with your investments, the higher the return is, typically. For instance, bonds and mutual funds are safer bets and usually offer modest returns, while playing the stock market has the potential to skyrocket your growth. Of course, you also run the risk of losing it all.
Compound interest will play a large role in the growth of your investment(s). The longer you hold your investment, the more it will grow exponentially.
Saving vs. Investing: What’s the Difference?
As you can see, savings and investments are very similar in many ways. The key difference, however, lies in the point of each.
Savings are funds earmarked for specific purposes down the line or as a safety net. To maximize these, you should choose savings vehicles that result in a modest return while still ensuring liquidity of your funds.
Investments, on the other hand, are intended to generate income. Yes, they are “savings” by virtue of definition. However, their purpose is to grow exponentially over time.
The other key difference between the two is regarding risk.
Savings typically involve little or no risk to the safety of your funds. Your bank is likely FDIC insured, and regardless of what happens to the economy and/or stock market, you will never watch your account balance decrease. (Unless, of course, you withdraw funds or incur fees.) Your funds are guaranteed, plus whatever interest the account balance can generate.
Investments involve their fair share of risk, though. Certain products are less risky than others, but there is a direct correlation between the returns you’ll see from your investments and the danger involved.
In other words, the higher the risk, the greater the chance of reward when it comes to investing. Your returns are never guaranteed and, in fact, you could very well lose your investment thanks to shifts in the stock market.
Lastly, there is a notable difference in liquidity between the two. If you need your funds to be accessible in case of emergency, savings vehicles are your best bet. This will ensure quick access to cash when you need it most.
Your Saving and Investing Timeline
So, which financial goal should you choose to focus your efforts on, between saving and investing? For many households, doing both can feel like too much of a strain on the monthly cash flow, so one has to take precedence… right?
The truth is that saving and investing are both incredibly important. Without adequate savings, you could wind up in a bind if sudden expenses pop up, or find yourself unable to reach certain goals down the line (such as making a down payment on a home).
On the flip side, the key to successful investing really lies largely in compound interest. The earlier you start investing, the more your money will grow over time. This is true even if you “catch up” and contribute the same amount to the account later on.
But if your financial situation simply won’t allow you to focus on both investing and saving right now, there are some times where one is more important than the other.
As mentioned above, one of the most important factors in the investment game is time. Without time, you can’t allow compound interest to do its work with your money… which means losing out on growth (read: free cash) in the long run. Let’s look at an example.
In the first scenario, you begin saving at age 25. You make an initial deposit of $5,000 into an investment account, which has an average annual return of 8%. You then continue adding $200 a month into this account for the next 30 years, until you retire at age 55.
When retirement rolls around, you will have contributed a total of $77,000 into that account, spread out over 30 years. However, with an annual growth of 8%, you will have approximately $322,193 waiting for you… all thanks to compound interest and time.
However, let’s say that you decide to put off investing for a few years. You start at 35 (instead of 25) and save $300 a month (instead of $200), still planning to retire at 55.
While playing catch-up is still better than not investing, you’ll be losing quite a bit in the process:
In the end, you will have contributed the same amount ($77,000) and retire at the same time. However, your money won’t have had as long to compound and grow, resulting in a total balance of only $188,048. That’s $134,145 lost!
Setting Your Priorities
If possible, work toward both your savings and investment goals at the same time. Even if you can’t dedicate as much to either as you’d like, the power of compound interest is important for your money’s growth.
The ratio of savings to investments is up to you and dependent on your needs at any given time. If you don’t have a comfortable nest egg saved, you may want to focus on savings for a while and let investing take the back seat.
If your savings accounts are sitting pretty and you aren’t worried about unexpected expenses, you can focus on investing instead. Once a year, take some time to reevaluate your situation and adjust contributions as needed.