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 an IRA Account?
When it comes to saving for retirement, the 401(k) gets all the attention. It’s easy to see why, too.
Many people are offered employer matching options in their 401(k) plans, a major incentive to save in those specific accounts. There are very few things better than free money.
But investors should also utilize some of the other retirement savings vehicles out there, especially their IRA accounts.
Here’s an overview of IRA accounts, including what they are, the benefits and how you can start using one today to save for your future.
The Basics of IRAs
An IRA (it stands for individual retirement account) is a type of investment account that shields gains from taxes. Depending on your employment status, there are several types of IRAs. Folks with regular jobs will open traditional or Roth IRAs, while self-employed people or business owners will use SEP or SIMPLE IRAs.
While each of these IRAs offer slightly different rules, we’ll just focus on the major difference between the two types of IRAs for regular folks – traditional and Roth IRAs. Your contributions for a traditional IRA are tax deductible (provided you make under $75,000 per year filing individually or under $124,000 filing jointly), while Roth IRA contributions are made with after-tax dollars. That means any gains from a Roth IRA will accrue on a tax-free basis, while you’ll be stuck paying taxes on traditional IRA gains once you start pulling the cash from your account, something that is mandatory starting at age 72.
You can only open an IRA account with a company that is registered with the IRS, a list that typically includes major banks, brokerages, or other types of investment firms.
Additionally, you can only contribute to an IRA using traditional earnings. That means that income like social security, child support or investment gains are not eligible.
Each of the different types of IRAs have investment limits. Both traditional and Roth IRAs are limited to a maximum contribution of $6,000 per year, with Roth IRAs offering a maximum investment of up to $7,000 annually if you’re 50 or older.
Most IRAs are self-directed, which means the account holder will be making all the investment decisions. You’ll have your choice of a multitude of different investment products, including individual stocks, bonds, mutual funds and exchange traded funds. You can also buy real estate or tax liens through a traditional or Roth IRA.
And finally, since IRAs are only supposed to be used for retirement, you’ll be hit with an early withdrawal penalty if you start taking your cash out before age 59 and a half. This early withdrawal penalty is usually 10% of anything taken out of the account.
Which Is Better – IRAs or 401(k)s?
The big benefit of an IRA over a 401(k) is the tax status of the former. Remember, Roth IRAs grow on a tax-free basis. You’ll end up having to pay taxes on both traditional IRAs and 401(k)s when it’s time to start making withdrawals. That’s a big advantage for Roth IRAs right there, and it’s a main reason why so many Americans focus on that account.
Another advantage to Roth IRAs is you don’t need to start making withdrawals by the age 72 deadline. You can, in theory, let your Roth grow forever. Just remember that unless you’re working, you can’t add anything to the account.
The big advantage to 401(k) plans is the employer match. Your employer must open a 401(k) for you, while opening an IRA is usually an individual’s responsibility. You can also contribute much more to a 401(k), with the limit for the 2020 tax year up to $19,500 if you’re under the age of 50 and $26,500 if you’re older than 50. There’s potential for your 401(k) to get quite big over time, while IRA account balances are usually a little smaller.
Many Americans are using a combination of the two to save for retirement, with many focusing on Roth IRAs because of their tax-exempt withdrawal status. The tax savings from contributing to a traditional IRA aren’t especially needed because these folks are also saving in a 401(k) plan.
When Should You Start Using IRAs?
The obvious answer is as soon as possible. The miracle of compound interest means time in the market is the easiest way to really goose your retirement savings.
Before you invest in an IRA, be sure to think about a few things. If your income is low, for instance, don’t put money to work in a traditional IRA. The tax savings will be negligible. Instead, use a Roth IRA and save the traditional IRA contribution for a better time.
Most people use both kinds of IRAs in a more traditional sense. They graduate from college, start working, and then it’s time to begin putting money aside for retirement. This is exactly when the average person would start using an IRA, and it’s a sound strategy. Leave the fancy tax avoidance strategies for the pros and just start saving in a normal way.
How to Set Up an IRA
Most IRAs are self-directed, which means it’s up to you to set one up. Fortunately, the process is straightforward.
The first step is to find a company to host your IRA account. There are hundreds of different companies out there that have the proper IRS approval to offer IRAs. One way to pick the correct one is to identify the type of IRA you’re looking for. If you’re looking for a hands-off approach to investing, a company specializing in that would be a good idea. Or, if you want to actively trade, then a discount stock brokerage would be a better solution.
Remember, the institution that has your IRA shares this info with the government. This means applying for an account will take a certain amount of patience and paperwork. They need to do things correctly or risk losing all those accounts.
One solution that will make the IRA application process a little easier is if you go with your existing bank or stock brokerage house. Remember, they have all your information on file already. That’s the biggest part of the process, and an important step you’ll skip if you have an existing relationship with the company.
Finally, once the account is set up, you’ll have to decide what to do with it. Even if you take a hands-off approach and just throw the cash into a diverse portfolio of passively managed exchange traded funds, you’ll still have to monitor it and ensure everything is going to plan.
The Bottom Line
Opening an IRA is one of the most important moves you can make to secure your future. Now you must move onto the hard part, which is making sure you’re consistently throwing money into the account. Save consistently for a few decades and you’ll be well on your way to a prosperous retirement.