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.
What Is a Good Debt to Income Ratio?
Unfortunately for many, debt is simply a part of their life.
As you likely already know by now, there are good forms of debt and not so good forms. Some, like student loans, a car loan, or a mortgage, can help lead to bigger and better things. After all, real estate tends to go up, most need a car to get to work, and university grads do tend to make more than their lesser educated peers.
But that doesn’t mean people should strive for a limitless amount of good debt. The last thing you need is all your cash heading out the door in the form of various payments. That leaves nothing left for necessities like food, clothing or utilities.
Life is a delicate balance. Most of us can’t afford to buy everything we want. But some go in the exact opposite direction and live a simple life free of all forms of debt because they’re petrified of getting in over their head. The ideal solution is somewhere in the middle. Having some debt is just fine. You just have to figure out how much is best.
Let’s take a closer look at what is a good debt-to-income ratio. Just how much can you afford to borrow, anyway?
Let’s start with a closer look at what exactly a debt-to-income ratio is.
Simply put, it’s the percentage of your income that gets spend on debt each month. For instance, if you make $5,000 per month and spend $1,000 per month on debt payments, you have a 20% debt-to-income ratio.
On the surface, it’s a simple concept. It gets a little more challenging once we delve a little deeper into the topic.
For instance, should we use gross income – income before deductions like taxes and Social Security – or should we use net income when figuring out a debt-to-income ratio? Most argue we should use net income, since it’s not like taxes and other deductions are optional. But others say we should just create a reasonable debt-to-income ratio based on gross income that factors in these issues.
Another wrinkle in debt-to-income ratios might be how aggressively you tackle your debt. Take mortgages as an example. Some folks choose to take a 15-year mortgage to tackle that debt quickly. Naturally, that increases their payment. So, they might have a big debt-to-income ratio, but it’s self-inflicted.
We can continue to add variables all day, but the point is clear. A debt-to-income ratio is a concept that becomes more complex as we add variables to it. Most folks stick with a simple version when they look at their own personal finances, which is a smart solution.
What’s the Ideal Debt-to-Income Ratio?
Perhaps the best source I’ve seen for considering your own debt-to-income ratio comes from the Canadian government.
The Canadian Mortgage and Housing Corporation (CMHC) is an expert in both mortgages and housing. This Canadian government agency has crunched the numbers and identified what percentage of someone’s income can be safely spent on their debt obligations.
After years of research, CMHC has come up with a conclusion that works well. They figure people can spend up to 42% of their income on debt. Note that this always includes a mortgage payment as well. Even if you’re just a renter, I’d argue this ratio still makes sense. After all, you need a place to live. This necessary payment is essentially the same as having debt.
CMHC’s debt service ratio can give us a clue as to how much non-mortgage debt is ideal too. You see, there are two debt service ratios the company uses to determine how much house someone can afford. They say the average person can afford to spend approximately one-third of their income on their mortgage alone.
Combine that with the total debt service ratio, and the conclusion is clear. A good non-housing debt-to-income ratio is approximately 10% of your total income.
The CMHC calculation isn’t 100% ideal – for instance, it doesn’t factor in housing costs like property taxes – but I’d say it’s pretty darn reasonable.
How to Bring Your Debt-to-Income Ratio Down
The easy way to bring your debt-to-income ratio down is to pay off your debts. This much is obvious.
This is where the debt snowball effort can really shine. Say you have a small $2,000 debt but it requires a $400 monthly payment. Putting all your effort into eliminating this small debt will free up cash flow while lowering your debt-to-income ratio significantly.
Most debt isn’t that simple to eliminate, however. It’s long-term debt like student loans or a mortgage. There are only two ways to get your debt-to-income ratio down in this scenario.
The first way is to refinance these loans into something with a lower monthly payment. This will bring short-term relief, but it will inevitably cost more interest in the long run. You must weigh this option carefully before going down this path.
The other is a much better solution, but I’m the first to admit it’s not easy. The best way to decrease your debt-to-income ratio is to increase your income. The debt stays the same, but you have more disposable cash for everything else in your life.
It isn’t the 1950s anymore; making more money isn’t as simple as requesting a meeting with your boss. But it’s certainly not impossible. Easy ways to increase your top line might be getting overtime at work – assuming it’s even offered – or taking on some sort of side hustle.
The Bottom Line
It’s important to keep your debt-to-income ratio low. If you don’t, you run the risk of eventually being overwhelmed with debt.
Typically, you’ll want to stay within CMHC’s guidelines and keep your total debt-to-income ratio in the 40% range, a number that includes housing. It’s a reasonable amount to spend whether you’re renting or paying off a mortgage.
If you find yourself paying too much towards debt, don’t sweat it. You can take actionable steps – like paying off your smallest loan quickly to free up cash flow – to make your situation better. And increasing your income is also a good strategy.
Spending the correct amount of your income on debt will ultimately lead to a healthy financial life. You might not be able to afford everything you want but keeping your debt to a reasonable level will ensure a lifetime free of financial worry.