Estimated Payments

Have you ever had an argument about the smartest person who ever lived? The discussion usually revolves around Einstein, Stephen Hawking, Leonardo da Vinci, Newton, among others. One person always throws out William James Sidis because he has the highest IQ ever recorded…show off. The argument then divulges into whether IQ is the sole marker for intelligence and so on and so forth. Being the smart aleck that I am, I always like to say it was Milton Friedman because he is the main person credited for coming up with the US Income Tax Withholding system which forever changed how we view taxes. But, I’m only half kidding.

Many people view their tax liability based on the amount they were refunded or owed in the prior year. “I got $1,200 back last year” or “I had to pay in $2,000.” They forget one big thing. Each paycheck that they receive takes money out to pay for federal and state taxes, among other things. They usually don’t realize that they may have paid in $10,000 throughout the year. All they think about is how much they paid/received in April. There is one exception to this general rule…small business owners.

Small business owners always know how much they pay in taxes. Here’s why. They must make payments every quarter! The average small business owner is paying 20-30% of their net income in federal and state taxes. Those checks do not go unnoticed. Owners must calculate their tax payment each quarter based on their net income projections for the year.

What happens if you don’t make estimated payments? I see this a lot with new businesses. Aside from the big tax bill you will pay in April, you will also be penalized for underpaying during the year. This creates a major burden for owners trying to grow their business. It becomes an ongoing issue because they end up getting behind each year trying to pay off the previous year’s taxes.

Here are some tips to help all you small business owners take care of your estimated payments throughout the year.

1)     Keep good records – You must be able to estimate your Net Income each time that a payment is due.

2)     Figure out your tax rate – Remember, this will be your personal tax rate for almost all of you. There are many online calculators that can help with this. You can also ask your tax preparer.

3)     Don’t forget Self-Employment Tax – Small business owners must pay the employer and employee portion of payroll taxes (Social Security, Medicare, etc.). This tax is 15.3% of your self-employment income. That is in addition to your regular income tax rate.

4)     Compare to last year – Does this payment make sense based on your prior year return and the amount of income tax you paid?

5)     Set aside money – Now that you are keeping good records, set aside money each month for your quarterly tax payments. Some people prefer to keep this money in a separate savings account.

6)     Withhold extra from paychecks – If you or your spouse still earns a paycheck, you can withhold extra instead of paying the full quarterly amount. Your business is taxed on your personal return so these withholdings will be included in your estimated payments.

7)     Ask for advice – Don’t be afraid to contact a tax professional to help estimate your quarterly payments. They can make sure you won’t be in for a surprise in April.

Estimated payments are extremely important. This post is meant to help you understand why they are important and how to develop a routine to make the payments. Small business owners can get into a big mess if they don’t make estimated payments. Luckily, for those of working as an employee, Friedman took care of this years ago.

Do me one favor after reading this. Find your last tax return and look at Line 63 on page 2. That is how much tax you paid. Split that into quarterly payments and imagine having to write those checks. Yes, you are still in the same situation financially, but we all know it is easier to take a little out of each paycheck. Just try to keep that in mind when you listen to small business owners discuss taxes. The calculation may be the same, but the process is very different. A process that can invoke strong emotions.

Mike Zeiter, CPA/PFS

Backdoor Roth

Tax Loophole – A provision in the laws governing taxation that allows people to reduce their taxes. The term has the connotation of an unintentional omission or obscurity in the law that allows the reduction of tax liability to a point below that intended by the framers of the law.

I am going to have a nerd moment for a minute but bear with me. I can’t stand the improper use of the term tax loophole in articles. I pulled the definition above from Dictionary.com. It seems a little misleading to me. The definition should be rephrased to emphasize the unintentional omission or obscurity section. That is what makes something a loophole. Everything else that allows you to reduce your taxes should just be called tax laws. For instance, one of the first articles that comes up in a google search lists the American Opportunity Credit as the first tax loophole. This is not a loophole! It is a tax credit designed specifically to help those paying for higher education.

Enough ranting…

The Backdoor Roth strategy is one item that, in my opinion, fits the term of a tax loophole. The law is written to prevent high earners from contributing to a Roth IRA. This strategy is a simple solution for that group. I will cover the details of how it works and who should consider it.

A Backdoor Roth contribution occurs when you make a Nondeductible IRA contribution and then subsequently convert the contribution to a Roth IRA for the same tax year. The key element of a Backdoor Roth is that the traditional IRA contribution is not deductible. The conversion to the Roth IRA means that the money will never be taxed again.  

Is it right for you? The most common scenario is young workers who do not have a workplace retirement plan, such as a 401k, but make too much to contribute to a Roth IRA. Young investors who have a long time until retirement can see significant tax-free growth in these accounts. The Backdoor Roth is also beneficial for people who are looking to contribute to a retirement account but can't deduct a traditional IRA contribution. The Roth contribution phase-out limit in 2018 is $135,000 for single filers and $199,000 for married filing joint filers.

Let’s go through the step-by-step process. The ideal scenario is to make your contribution to the traditional IRA and then immediately convert it to a Roth. You can make contributions throughout the tax year, but the conversion must occur before the tax-day deadline. There are tax consequences if you invest the original contribution and then convert a higher amount to the Roth IRA. You also need to file Form 8606 with your tax return for the tax year that you make the contribution. Once you complete the steps properly, your Backdoor Roth contribution will grow and can be distributed tax-free during retirement. This scenario is much more beneficial than if you were to keep the amount in a traditional IRA that would be taxed at ordinary income tax rates when withdrawn in retirement.

You may be thinking that it is pointless for someone earning that much to want to contribute to a Roth IRA because there is no tax benefit in the current year. However, if they can’t deduct a contribution to a Traditional IRA but still want to put more towards retirement, this allows them to receive the future benefits of a Roth.

That covers the basics of a Backdoor Roth. Hopefully, you understand why I think this is one of the most common tax loopholes available. The tax law is written to prevent high income earners from making Roth IRA contributions. This strategy is a quick and simple way around the law. If you need help planning your Backdoor Roth strategy, or you just want to open your own retirement account, contact me for help!

Mike Zeiter, CPA/PFS

Business Organization Q&A

Entrepreneurs are changing the world one innovation and one solution at a time. Think about Uber. Two guys couldn’t get a cab one night and they have now changed the entire industry. Or Tesla. Elon Musk and friends decided that people shouldn’t need to compromise looks and performance if they want an electric car. There are people all over with a passion to solve the world’s biggest problems. This is one reason I always try to provide services to small business owners that allow them to focus on the core function of their business. I can’t imagine Elon Musk stopping his work so he can go categorize his expenses at the end of the day.

One of these items that all business owners must deal with is setting up their business structure. All new businesses must choose the type of entity they would like to be. The decision will have a significant impact on your taxes, ownership options, legal liability, and the amount of paperwork needed. There are a variety of questions that business owners ask during the process. So let’s do a Q&A so I can try to help answer some right now!

Note: This post is meant to gain a basic understanding. There are many variables to consider when choosing your business entity.

What types of entities can be formed? Sole Proprietorship, Partnership, Limited Liability Company, and Corporation

There are four different types of business entities. Some of these types have subtypes as well. For instance, a corporation can be an S Corp or a C Corp. There are also default entities that form if you don’t choose on your own. If you are the sole owner of a new business, you will be considered a sole proprietorship. If you and someone else form a business, the IRS will consider it a general partnership. The default may work for you but is most likely not the best option available.

What aspects of the business should I be concerned about? Business Taxation, Legal Liability, Ownership Options, Cost of Operating, Future Needs

There are countless items that will factor into your business entity decision. Taxation and legal liability tend to be atop everyone’s list. Ideally, your business will be set up for you to minimize each of those two items. However, you also want to understand the ownership options and think about where you see the business going in the future. Do you want to be the sole owner of the business forever? Do you want to take it public someday? How much do administrative paperwork and state filings do you want to deal with? Start by listing your preferences in order of importance. That will allow you to figure out what entity fits the most important aspects for you.

How is my business taxed? Flow through or Entity Level. Schedule C, E, or F. Forms 1065, 1120-S, or 1120.

This question can be real fun for the tax nerds out there like me! In general, you will either pay income taxes at your personal tax rate unless you form a C-Corp. That is what is meant when someone refers to a “flow through entity”. Which form would from the list above to file your taxes? That depends on the type of business entity that you establish. The tax return preparation is one administrative area that can result in higher annual costs for the more complicated business entities.

Which makes most sense for your business? What are you most concerned with?

I hate to answer a question with another question, but it all depends. For instance, of you want the business to be passed on to someone when you die, a sole proprietorship would not work under any circumstance. I would strongly advise you to keep it simple. You can almost always change your business entity in the future. Don’t form a C Corp just because you may want to go public someday. It isn’t worth the hassle in your first few years of business.

How do I register? Find more info on your state government website.

Once you have determined the best entity for your business, you are ready to file the paperwork. Other than a sole proprietorship, which does not require state registration, you can find out more info about how to form your business entity from your state government. You should also research any business licenses you may need from your local municipality. You can do the forms on your own, or you could use a lawyer or legal website. Most won’t charge too much for the business filings.

Each one of us has strengths and weaknesses. Most small business owners should focus their time and talent on creative ideas and growing their business. This is one of those items that is much easier to discuss with a lawyer or CPA to let them figure out the best option for your business. The tax savings alone will probably cover the expense to work with them. Just make sure to have your priorities straight…kind of like everything else in life!

Mike Zeiter, CPA/PFS

P.S. – Check out the article below to see my comments about forming a business for ordinary and passive income!

www.incfile.com/blog/post/ordinary-income-versus-earned-income

Gift Taxes

For those of you who don’t know me that well, let me share something about myself. I love to give gifts! It doesn’t matter what the occasion is. I spend a lot of time planning what to get people. These gifts can be items, experiences, personal services, and of course, there are also times when it is best to just give cold hard cash. The most important thing to me is making sure that the gift is the perfect thing for the person receiving it. The last thing I want to think about during this process is taxes!

This blog post will cover the common tax questions people have when giving/receiving gifts. My guess is that you don’t think about taxes for 99% of the gifts you give and receive. However, at some point in your life, there may be an instance where you will want to make sure that generosity doesn’t result in a tax bill. At that point you can think to yourself, “Boy, I am glad I read Mike’s blog post six years ago!”

General Rule – Most gifts transfer tax free. The receiver can do whatever they want with the gift without having tax issues. The IRS doesn’t care when you give your dad another pair of socks for Father’s Day.

Appreciated Assets – The first twist to our tax-free rule is appreciated assets (i.e. stocks, homes, artwork). These items still transfer tax free, but the gift receiver will have tax consequences if they sell the asset.

Example: I have $2,000 in shares of Apple stock that I want to gift to you. I paid $500 for it a few years ago. Once you take ownership, you assume the $500 cost basis in the stock. That means that if you sell it the next day for $2,000, you would have to report a $1,500 gain on the sale. The details can get confusing, but it is important to know that selling stocks that you received as a gift will not be a tax-free transaction.

Note: This law is different if you inherit appreciated assets from someone who has passed away.

Annual Exclusion – The IRS sets a limit for the maximum value you can give a person each year without any tax consequences. The amount in 2018 is $15,000. This means that every person can give any other person up to $15,000 worth of gifts during the year. This amount may be split between husband and wife. If you are married, you could give up to $30,000 per year. However, if you split gifts, you will need to file the gift tax return even though there is no tax that needs to be paid.

Lifetime Exclusion – What happens if you go over the $15,000 annual exclusion limit? Don’t worry just yet! Everyone has a lifetime exclusion amount that they can give before causing tax issues. The current amount is $11.18 Million. For most people, this amount seems like a non-issue. However, the lifetime exclusion is what factors into gift tax issues upon death as well. This amount has changed many times and will almost certainly change again before you die. Just know that if you give gifts over the annual exclusion, you will have to file a gift tax form to reduce the lifetime exclusion.

If you manage to use up your entire lifetime exclusion, then you would have to pay gift tax on the amount given. It’s important to remember that the person giving the gift is responsible for paying the tax. As you would imagine, most of the time this isn’t an issue until someone dies and the estate is being settled and gift taxes need to be paid during that process.

Hopefully this helps you understand some more about the laws relating to gift taxes. You may never have to worry about it, but it is important to dispel any rumors that you may hear about gift taxes. There may also come a time when you are giving gifts that would make you consider these factors. In the meantime, keep giving gifts! There is no greater feeling that finding the perfect way to make someone else feel loved.

Mike Zeiter, CPA/PFS

End of Tax Season

Tax season has finally ended! Now it is time to sit back, relax, and forget that the IRS exists for the remainder of the year, right? Not quite. I am asking you, as a friend, to do a couple things before you close the book on your 2017 taxes.

Why would I ask you to do such a terrible chore? Because it is much easier to start tax saving strategies in April than waiting until December to see what you can do before the end of the year. It’s also a better strategy than waiting until you are preparing your return next year and realizing you could have made some minor changes during the year to save on taxes. Spend about an hour of your life and go over the following items before you forget everything about 2017.

Review your return – Just go through each page on your tax return and make sure everything looks correct. Most tax preparation software doesn’t allow you to view the return until you finish and pay. Most people prepare returns in their software and just hope the result is a big green number on the screen. It is important to make sure that you didn’t mistype anything or forget to include some deductions. You can also compare it to your prior year return if you have that on hand. If you notice a mistake, you can always amend the return to correct it.

Check your payroll withholdings – Are you getting a very large refund, or do you always seem to owe money? Find a recent paystub and see how much is being withheld on your paycheck. Focus on the FIT (Federal Income Tax) amount and the state income tax as well. The ideal situation would be that you pay in enough so that you owe nothing at the end of the year. Some people prefer to withhold extra to act as a savings account. I understand that concept, but there are better ways to save money from each paycheck.

Consider Retirement Options – This category can get confusing very quickly so keep it simple for now. If you have a retirement plan at work, how much could you save on taxes if you increased your contribution? If you don’t have a plan through your company, have you considered an IRA? Do you own a small business? Small business retirement plans can help you save a significant amount on taxes. Roth accounts are important to consider as well. They may not save money on taxes now, but you won’t pay taxes on these accounts in the future if you follow the rules for distributions. The important thing in this section is to know how much you put towards retirement and how it impacts your tax return.

2018 Changes – This year is an important year for understanding your taxes because the withholding amounts changed. You may have noticed your paycheck increase because of the new tax law. Make sure that your payroll withholding is still in line with your estimated taxes for 2018. You can work with a tax professional or find an online calculator to estimate this. This is important so that you can avoid any surprises next April.

You don’t need to be a tax expert to do these things. They will help you understand your tax situation and allow you to plan better for the future. Don’t put it off until December and start worrying about how to save on taxes before the year ends. Get a plan together that fits your lifestyle and can help reduce the tax burden that you incur each year. I promise that you will thank yourself for doing it!

Mike Zeiter, CPA/PFS

ETFs and Mutual Funds

Finance professionals love to sound smart. It seems like the ideal situation for the financial world would be for the average person to listen to them and think to themselves, “Man, that guy/gal is brilliant. I only understood ten words of that, but they must know how to make money.” Luckily, the topics usually aren’t as complicated as they sound. As for the topics that are… those are usually a good way to lose money fast.

One topic that has become more relevant in recent years is the difference in Exchange Traded Funds (ETFs) and Mutual Funds. ETFs are a newer product that have gotten a lot of media attention, but most people don’t understand the differences between them and mutual funds. I am going to cover how these investments are very similar, but how ETFs have a couple characteristics that have made them very popular recently. Then we can figure out how you should use these investments in your life.

How are they similar?

Both mutual funds and ETFs hold a group of stocks or bonds. They are classified by what type of investment they hold. Investors use them as a simple way to diversify their portfolios. Each fund has a company and manger(s) that makes sure the fund is in line with the investment goal. Let’s say you want to add small US companies to your portfolio. You could research and pick one or two companies and buy those stocks. However, these companies usually have less information and can be more at risk of failing. Instead, you can buy a small cap fund. This allows you to invest in hundreds of small companies and diversifies your portfolio. Vanguard offers a mutual fund (ticker – NAESX) or ETF (ticker – VB) that hold almost the exact same investments. So which fund do you choose?

How are they different?

Passive Investing – Most ETFs are set to track a benchmark. That means that the manager is only changing the holdings when the benchmark changes. Mutual funds can have active or passive managers. Active managers who buy and sell investments within the funds to try to beat the benchmark that they are compared to. ETFs are usually only set up as passive investments.

Traded – One thing that people love about ETFs is that they are traded during the day. Mutual funds are all priced at the end of the trading day. If you put an order in to buy or sell a mutual fund, you must wait until the next time that fund is priced (end of the trading day) before the transaction occurs. ETFs can be bought or sold throughout the day. You can buy an ETF in the morning and sell it in the afternoon. It may not be a great long-term strategy, but it is allowed.

Taxable Gains – Each year, mutual funds distribute any capital gains that occurred within the fund. These gains could potentially be short term which would be taxed at your ordinary income tax rate. That means that if you own a mutual fund in a taxable account, it may result in extra income even if you didn’t sell the fund. A good strategy is to hold ETFs in your taxable accounts and mutual funds in your tax deferred accounts such as IRAs.

Fees – ETFs usually charge less in fees. Mutual funds cost more to run and manage. In using our Vanguard funds above as examples; the mutual fund charges 0.18% annually, but the ETF charges 0.06% annually. That doesn’t sound like a big difference, but that is 66% less in fees. These little changes can make a big difference in your overall success.

Why not all ETFs?

If you are a passive investor with a long time horizon, it may be the best option. One bad thing with ETFs is that you must pay a commission when you buy or sell them. Many mutual funds offer buying and selling with no fees. Also, there is the risk is human nature. ETFs could be bought or sold at prices different that the value of the holdings. If investors panic and sell these ETFs in a frenzy, the actual value of the holdings in the company may not properly reflect the value it is trading at. It’s a rare scenario that usually adjusts at the end of the day, but it can damage long term returns for investors that trade ETFs like stocks. One other thing to remember is that many ETFs are created to invest in certain types of companies or sectors (airlines, oil, technology, etc.). You need to be more aware of the investment objectives when you buy ETFs.

The important thing is to understand the investments that you have in your portfolio. Look at the funds you own and make sure that there aren’t better options. If you work with a financial advisor, ask him/her why you are invested in each mutual fund or ETF in your accounts. If they are unable to explain it to you in a way that you understand and feel comfortable with the choices, get a new advisor because investing doesn’t have to be complicated to be successful.

 

Mike Zeiter, CPA/PFS

Millennial Careers

We have all heard the phrase before. “Millennials don’t (insert grumpy old man comment) like we used to.” Yes. It’s true. Times change. When Grandpa Reginald was a child, his elders complained to him about how using the telephone has made him lazy and ruined his communication skills. One complaint that I want to look closer at today is, “Millennials have no respect for the companies that hire them. They just move from job to job without any gratitude.” That is true. People switch jobs much more often today than they did 30 years ago. But why do people move jobs so much now? There are a variety of reasons that experts cite for this new change, but I want to focus on one I don’t hear people talk about as much…pensions.

There are two groups of retirement plans; defined benefit plans and defined contribution plans. Pensions are considered defined benefit plans because companies put money in the plan for employees. Defined contribution plans include 401(k) plans, 403(b) plans, and others where the employee is responsible for contributing the majority of the money.

Pensions are great. You work for a company for 35 years until you are ready to retire. Upon retirement, you receive a monthly payment until you pass away. Unless the company or government entity that you worked for goes bankrupt, you are guaranteed that money each month. Some pensions will even pay a portion to your spouse after your death.

So what does that have to do with the millennial generation? Pensions are virtually nonexistent now. It is highly unlikely that your company offers a pension unless you work for the government. Because of the high cost of pensions, most companies have switched to 401(k) plans where the employees are primarily responsible for retirement savings. One aspect of a 401(k) is that you get to keep the money you put in and any vested amount from your employer if you leave the job.

Companies have lost a major perk for employees to stay with them for the long term. Raises and promotions are nice, but a 3% raise doesn’t compare to a possible 10-20% jump if you switch companies and move to a higher position. Plus, you are now able to take your retirement account with you when you leave.

Regardless of your view of this new generation, remember that everyone responds to incentives. Many Millennials have lost the financial incentive to stay at one company for an entire career. So why not try out that new job at a different company, what do they have to lose?

Mike Zeiter, CPA/PFS

Invest in Yourself

What comes to mind when you think about the word Investments? Most people will have words like stocks, bonds, mutual funds, and real estate pop into their head. Now I want to think outside the box a little bit. One of the best investments is something that most people don’t consider; an investment in yourself. And before we get started, this does not include skipping work for a day to go shopping!

What would with$10,000 if I gave it you tomorrow?

Most people could find a way to use the money. It would probably be in the form of some combination of spending, saving, paying off debt, and investing. I hope that spending would be a smaller portion of those decisions, but you can do whatever you want with this money. Why not buy a new motorcycle if that’s what makes you happy? Now, let’s change it up a little bit.

What would you do if I required you to invest that $10,000? I know…how awful. How dare I restrict the free money I just gave you in our imaginary situation. Which investments would you choose? There are thousands of different investment options in the stock market alone. For those of you want to pay off all your credit card debt, I understand that paying off something with 20% interest is the same as investing and earning 20%. That’s not allowed for this situation. Give yourself a minute and think about it.

Hopefully, you started to analyze all the risks and returns between different investments. Did any of those investments involve spending money on furthering your career? This type of investment could change your life.

Everyone has probably heard the phrase “An investment in yourself will pay dividends for the rest of your life.” It makes sense. If you are 18 years old deciding between college and starting a career, going to college will probably allow you to make more money throughout your life than if you immediately started working a full-time job. But it could work if you are 40 years old as well and wanting to expand your career choices. Let’s look at some examples of how you could use $10,000 towards an investment in yourself.

College Degree - $10,000 probably won’t buy you a full degree, but it’s a good start. A combination of community college and online courses may get you close. This could be the start of a four-year degree to start your career, or it could be an MBA to provide you with management possibilities at your current job. The important thing with college degrees is to choose one that accelerates your career and will allow your income to increase. Spending $100,000 on a private college that will allow you to work in a career making $40,000 a year for life is not a good investment.

New opportunities - Are you ready for a career shift? Find out what certifications would be beneficial for the career you desire. Let’s say you would like to get a job in computer programming. There are probably one or two programming systems that all employers will want you to have experience with. Spend the money to get certified in Java or C++. That will make your interviewer realize that you are serious about the career change.

Current Career – Maybe you love your job and want to stay with your company until you retire. That’s great! Are there any certifications that would help you move within the company? For instance, most accounting firms won’t promote to manager without a CPA license. The Six Sigma program is also a great example of a certification that could allow you more opportunities in your current career. Spend the money to get a certification that will allow you more opportunities in the future. Some companies may even help pay for a certification. However, like a college degree, don’t waste your money on a certification that doesn’t add value to your career.

Most of these investments require a lot of money, time, and hard work. The long-term impact will be worth it. Aside from the obvious benefit of a higher salary, you will have flexibility throughout your career. You may love your job now, but that could change in five years. Investing in yourself could help you in the future from feeling stuck without any options. Now think about that $10,000. What investment in yourself would you make?

Mike Zeiter, CPA/PFS

Emergency Funds

An emergency fund is usually the first goal that everyone focuses on when they decide to take control of their finances. A recent study showed that over 50% of Americans wouldn’t be able to come up with $400 if they needed to. Most people just tend to spend what they have so there is never money left over at the end of the month. If they took $1 a day and put it in a jar, they would manage to save almost $400 in just over a year. So should you just grab a jar and start saving? Maybe…

Once you decide to set up your emergency fund, let’s figure out where you should keep it. Although a jar is better than nothing! There are many different options, but let’s first discuss the basics of an emergency fund. Generally, it should be 3-6 months of expenses. If you aren’t there yet financially, make it at least $1,000 to start. This money is for emergencies only. New shoes are not an emergency. A new TV is not an emergency. These are things you expect to replace. This money should be used for things such as medical emergencies, car accidents, or loss of a job. Non-emergency savings should be kept in a separate account.

Where should you keep your emergency fund? People get really frustrated about setting aside a pile of money in an account that earns virtually nothing. Unfortunately, this money needs to be accessible on the spot, so you don’t want it locked up in an investment that could go down in value. I could go through every investment type and give pros and cons for each, but I will focus on the best option. But first, don’t keep a pile of cash under your mattress. The last thing you want to do is try to convince your insurance company that someone stole $10,000 cash.

The best place for an emergency fund is a savings account with an online bank. Here’s why.

1)      The money is FDIC insured. The government will refund you if it gets stolen.

2)      These online banks pay around 1.0% on savings accounts. This is the best rate you can get right now for a risk-free investment.

3)      Choose a bank that you don’t have your regular accounts with. This will keep you from seeing that extra money and being tempted to use it.

Emergency funds are crucial to financial success. Don’t let something like a job loss completely bankrupt you. If you haven’t set up an emergency fund yet, start by transferring $100 a month to a new account. You will be off to a great start as long as you pretend it doesn’t exist until an emergency. Just remember that the extra 30% off those boots is not an emergency!

Mike Zeiter, CPA/PFS

How Interest Works

Do you have debt? Welcome to the club! Almost everyone in America has debt of some kind. Each piece of debt has a built-in interest rate associated with it. It seems that there are a lot of misconceptions in the world about how interest and debt payments actually work. That’s what I want to focus on today. I want you to understand how important that number is and how it impacts your debt payoff.

This can be confusing, but I will have an example at the end to help explain everything.

When you take out a loan to buy something such as a car or house, you receive an amortization schedule breaking down how each payment will apply to principal and interest. Principal is the debt itself, and interest is based off the rate that you qualified for. Interest is calculated monthly based on the amount of principal that is left. This is something that I don’t think is very well explained by those people selling you the loans.

I hear this phrase all the time, “You pay most of the interest in beginning so it isn’t worth paying extra.” Yes. That is true. But it is only true because the principal balance is larger at the beginning of your loan. Don’t let someone convince you not to pay down debt early because of that argument.

I have one more item to mention before the example. Don’t buy things based on the monthly payment. It happens all the time. People will buy a car as long as the payment is under $400 or whatever number works in their mind. Car salesmen know this, which is why they have started spreading loans over 60 and even 72 months. That’s 5 or 6 years! The average auto loan used to be 3 years. If you have ever sat in the sales room finalizing your purchase, you remember them saying that the tire warranty is only an extra $18/month. Focus on the actual purchase price of items and it will save you a lot of money long term.

Example: Congrats! You just bought a house. The final price was $300,000 and you managed to put 20% down so there is no PMI (Private Mortgage Insurance). The loan amount is $240,000 and you got an interest rate of 3.5%. The monthly payment is $1,427.71. You pay for insurance and property taxes in that payment totaling $350 each month.

The first payment is calculated by taking the total principal of $240,000 times 1/12 of the interest rate (3.5/12). Once interest is calculated, add in your insurance/property taxes. Then whatever is leftover is applied to principal. Let’s break down the first payment.

Interest = $700 ($240,000 x (3.5/12))

Insurance/Property Tax = $350

Principal = $377.71

Total = $1,427.71

You only pay down $377.71 of debt on that first payment! That amount is subtracted to calculate the next payment. Let’s break down the second payment.

Interest = $698.90 ($239,622.29 x 3.5/12)

Insurance/Property Tax = $350

Principal = $378.81

Total = $1,427.71

You get the point. But let’s say you wanted to pay down your house early. What would the effect be if you paid an extra $1,000 with your first payment? That would be directly towards principal. Let’s break down the second payment in this circumstance.

Interest = $695.98 ($238,622.29 x 3.5/12)

Insurance/Property Tax = $350

Principal = $381.73

Total = $1,427.71

This doesn’t seem like a big deal, but you just saved about 3 months of payments! That is $2100 in interest. Even if you were just able to pay $400, that would still be the equivalent of a double mortgage payment.

I hope this helps you understand how debt payments work. Paying off debt early does save money. Don’t let someone convince you to keep a loan around because the interest is deductible or that you’re paying extra interest in the beginning. That guy in the cubicle next to you doesn’t always know what he is talking about.

Mike Zeiter, CPA/PFS