How Flexible Spending Accounts (FSA) Work?

Posted on by Ryan

Flex Spending Accounts save you taxes on medical and health-related payments

If your employer offers what’s known as a flexible spending account for medical expenses (also known as a “flex spending account,” or “FSA”) then, if you enroll, you can have money withheld from each paycheck on a pre-tax basis that can be used to pay for medical, dental, vision, or similar expenses not covered by your insurance. In short, a flex spending account is a tax-efficient way to pay for out-of-pocket healthcare costs.

To illustrate how a flexible spending account works, let’s say that you are planning to have a special dental procedure that will cost $2,000. While this particular procedure is not covered by your health insurance or dental plan, it does qualify as medical procedure that you can pay for with your flex spending account. In fact, a flexible spending account works so well that when the procedure is done your dentist will bill you…$2,000. But wait, if a flex spending account is supposed to save you so much money then why are you still being billed $2,000 by your dentist? Where are the savings? What’s important to understand is that a flex spending account doesn’t lower your actual health care charges, i.e., a $2,000 dental procedure will still cost $2,000. However, paying for qualified medical and health-related expenses from a FSA does lower your tax bill. To illustrate, if contributed $166.67 each month to your flex spending account then your total FSA contribution for the year would be $2,000. Not only would that be enough to fully pay for your dental procedure, but it would lower your FICA tax and income tax as follows.

FSA Medical – Tax Savings	FICA Taxes	Income Taxes	Totals
Monthly FSA Contribution	$166.67	$166.67	$166.67
Times: Months in the Year	12	12	12
Equals: Annual FSA Contribution	$2,000.00	$2,000.00	$2,000.00
Times: Tax Rate	5.65%	21.00%	26.65%
Equals: Tax Savings	$113.00	$420.00	$533.00

		Monthly Savings	$44.42

What this table shows is that if you used flex dollars to pay for your dental procedure then you would lower your overall tax bill for the year by $533.00, which translates into a savings of $44.42 a month ($533.00 divided by 12 months). Viewing the savings a different way, if you paid for your dental procedure using an FSA, you would reduce the after-tax cost of your dental bill from $2,000 to $1,467 ($2,000 less the tax savings of $533), a savings of almost 27%! In my book those are attention-getting numbers for regular people looking for ways to use their money more effectively.

Special rules for the flexible spending account

It’s important to note that flex spending accounts have some rules, characteristics and limitations that you need to be aware of. Following are some of the key ones:

You have to sign up to participate in a flex spending account through your employer. Check your company’s website or contact your human resources department to find out how.
You have to make a decision in late November or early December of the current year (e.g. 2020) on how much of each paycheck you’re going to contribute to your flex spending account for the next year (e.g. 2021). Project your medical expenses as carefully as possible, because once you’ve made your decision you can’t change your mind unless you have a “qualifying life event” (a change in your marital status, the birth of a child, you’re starting a new job, etc.).
$3,500 is presently the maximum amount an individual can contribute to an FSA each year. These flex dollars can be used to pay for personal or family medical costs.
Your flexible spending account contributions are not refundable and you can’t “bank” them for the next year, so use all the money you contribute to your FSA by the end of the year or lose it forever![2]
On the positive side, you can file a claim for flex dollars in advance of having them withheld from your paycheck. For example, if you planned to flex $1,200 over the course of the entire year (equal to $100 per paycheck if you were paid monthly), then if you had a $1,200 worth of qualifying medical expenses in January you could immediately file for a full reimbursement (as opposed to having to wait until December when your monthly contributions finally caught up with your expenditures).[3]

How do you access your flex dollars?

So how do you go about accessing these magical flex dollars? Note that a flex spending account is not like money in a bank account somewhere over which you have complete control. In order to access money from your FSA you have to provide your insurance administrator with proof that you actually paid qualifying, unreimbursed medical costs. Once you’ve done so then they’ll reimburse you, either by sending you a check or wiring the money to your bank account. For example, if you had to pay a $30 co-payment out of pocket then you could submit that bill to your insurance administrator for a $30 reimbursement. But once again, you cannot get reimbursed for medical costs that were covered by your health insurance, only unreimbursed amounts!

Also – and this is very important – if you have any doubts about whether an expense qualifies for reimbursement that it’s important to check in advance with your FSA insurance administrator before spending any money (get their contact information from your employer’s HR group). Remember, one of the FSA administrator’s responsibilities is to ensure that flex reimbursements are not paid out unless they’re for qualifying expenses. With that in mind, here are the key questions I would ask your FSA administrator BEFORE spending a significant amount of money on a health/dental/vision/medical expense for which you want a flex reimbursement.

Is this procedure, item, treatment, etc. an expense that qualifies for a reimbursement from my flex spending account?
What documentation will you need in order to be able to provide me with a reimbursement for the expense? Can I simply spend the money and provide you with the receipt, or do I need a letter from a doctor or some other documentation in advance of making the purchase?

Again, it can be very expensive to assume! Resolving these questions up front eliminates surprises and helps you to avoid making a very expensive mistake. Remember, when following flex spending account procedures it’s not only what you spend money on that enables you to get reimbursed, but how you go about doing it is also very important.[4]

How do you estimate medical expenses prior to enrollment in an FSA program?

Given that you have to enroll in a flexible spend account program for the coming year in late November or early December, how do you estimate what your medical and health-related expenses will be with any degree of accuracy? To help, I recommend considering the following:

Knowns – How often do you have set appointments to go to the doctor, dentist or ophthalmologist during the year? What are your out-of-pocket costs for these visits? Do you pay any out-of-pocket costs for prescription medication that you take on a regular basis? What are your other fixed/known medical, dental, or vision costs?
Trends – You don’t always go to the doctor because you have an appointment. Sometimes you get sick, get injured, or have an accident. While it’s impossible to say for sure, try and take into account your overall pattern of doctor-type visits over the course of the year when estimating how much to flex each paycheck.
Special procedures – Like the dental example above, are you planning on any special health-related procedures in the coming year? Perhaps you are having LASIK surgery, or a string of rehab appointments that you don’t normally have. Again, if you’re aware of any significant one-time or recurring medical expenses coming up in the next year then be sure to take those into account.

Finally, even if you take these 3 things into account, recognize that it is still very difficult to say in November what your medical costs will be for the coming year. In other words, there’s no getting around having to do a bit of guesswork when it comes to deciding how much you should flex.

Is it better to overestimate or underestimate how much you should flex?

If you have to estimate how much to flex then, from a strategic personal finance point of view, are you better off underestimating or overestimating your medical/health costs? For example, modifying the dental example above, let’s say the dentist will not be able to determine the exact cost of the procedure until it’s actually under way. Instead, all he or she can tell you for now is that on the low end the procedure will cost $1,000 but, depending on what they find, the cost could be as high as $2,000. Faced with such uncertainty, is it better to estimate at the low end ($1,000), the high end ($2,000), or somewhere in between? The answer is that it’s more cost-effective to flex based on an estimate at the lower end of the range. To understand why let’s take a look at a few scenarios. First, assuming the total cost of the dental procedure ends up being $2,000, let’s see the financial difference between flexing $1,000 and $2,000.

Actual Cost of Dental (or Medical) Procedure	$2,000.00

A	B	C	D	E	F
Actual Cost/Flex Contribution	Combined FICA & Income Tax Rate	Tax Savings (A x B)	After-Tax Cost of Flex Dollars (A – C)	Out-of-Pocket Cost (Cost – A)	Total Cost (D + E)
$1,000.00	26.65%	$266.50	$733.50	$1,000.00	$1,733.50
$2,000.00	26.65%	$533.00	$1,467.00	$0.00	$1,467.00

				Difference	$266.50

What this chart shows is that if you flexed $1,000 then the after-tax cost of doing so would only be $733.50, but you would have to come up with another $1,000 out-of-pocket to pay the balance of your dental bill. Thus the total cost of your $2,000 dental procedure would be $1,733.50 if you flexed $1,000. On the other hand, if you flexed the full $2,000 then you could pay for the entire procedure with flex dollars, and it would only cost you $1,467.00 on an after-tax basis. As a result, if the procedure ended up being $2,000 then it would cost you an additional $265.50 if you flexed $1,000 instead of $2,000 (see the table above). But how can that be? Didn’t I just say that it’s generally a smarter, safer play to flex on the low side? If that’s the case then why did it cost more money? To see things in the right perspective, take a look at how things turn out financially if the procedure only turns out to be $1,000.

Actual Cost of Dental (or Medical) Procedure	$1,000.00

A	B	C	D	E	F
Actual Cost/Flex Contribution	Combined FICA & Income Tax Rate	Tax Savings (A x B)	After-Tax Cost of Flex Dollars (A – C)	Out-of-Pocket Cost (Cost – A)	Total Cost (D + E)
$1,000.00	26.65%	$266.50	$733.50	$0.00	$733.50
$2,000.00	26.65%	$533.00	$1,467.00	N/A	$1,467.00

				Difference	$733.50

What this chart shows is that if you flexed $1,000 then the after-tax cost of the dental procedure would be $733.50. On the other hand, if you flexed $2,000 the good news would be that you definitely wouldn’t owe anything out of pocket. But the bad news is that it would cost you $1,467.00 on an after-tax basis to flex $2,000, and if you weren’t able to find a use for the unused $1,000 that you flexed then it would end up costing you 733.50 on an after-tax basis (see the chart above)!

In summary, following the examples above, if you estimated your flex on the low end ($1,000) when the cost turned out to be high ($2,000) then you would have to come up with an additional $266.50. Of course that’s not great news, but if you estimated your flex on the high end ($2,000) when the actual cost was low ($1,000) then it would end up costing you $733.50, or a whopping $467 more that had to been more conservative (on the low end) in your flex estimate!

Find ways to spend excess flexible spending account dollars before the end of the year

Despite your best planning, efforts and intentions, what if you find yourself in a situation where you’ve overestimated the amount of flex dollars that you need for the year? In other words, following the example above, what if you’ve done all the health-related things that you planned, but you still have $1,000 flex dollars left (or whatever the amount happens to be)? The answer? It’s time to spend some money. I know that sounds a little weird, to manage your money effectively by spending it. But remember, according to the flex rules if you don’t use it you lose it…so use it! And how do you do that effectively, to your best advantage? Here are a few ideas.

Did you have one dental procedure done this year and you were waiting until next year to have another done? Consider rescheduling next year’s procedure for this year.
Have your kids evaluated by an orthodontist.
Get an eye exam so that you can get your eye prescription updated.
Get a new pair of glasses based on your updated prescription. If you already have an updated pair then get a backup pair for emergencies. If you already have a backup pair then consider getting a pair of prescription sunglasses (regular sunglasses would not qualify).
Load up on contact lens.
If you’re on prescription medication of any kind then get as much as you can before the end of the year.
Have everyone in your family get a physical.
Are you having LASIK surgery done to correct your vision? If you have a lot of flex left, but not enough to cover the entire cost, then consider having one eye done before the end of the year and the other eye done at the beginning of the next.
Obtain or replace medical equipment or devices, such as a wheelchair (but check to see if the expense qualifies before spending any money!).

In summary, as long as you don’t drastically overshoot the runway, it’s not too difficult to put excess flex dollars to work before the year ends. But keep in mind that advance planning will be needed. For example, if you call your dentist on December 15^th then you’re going to have a very difficult time getting an appointment, because everyone else with excess flex dollars is trying to spend their money at the same time you are! So again, be smart, don’t wait until the last minute…and try to do a more accurate estimate for the next year!

[1] FICA taxes are a combination of your Social Security and Medicare taxes.

Do I Have To File A Federal Income Tax Return?

Posted on by Ryan

“If it makes you smile, you gotta file.”

Identify all of your sources of income

When it comes to taxes, the first thing you need to do is determine whether you are even required to file an income tax return in the first place. And since it’s an income tax return, the easiest, most intuitive way to get a handle on whether you have an April 15^th tax filing requirement is to first list all of your sources of income for the prior year.[1] To be comprehensive, don’t worry right now about whether the income may or may not be taxable; just list the source of any money or property that you received during the year, which may include:

Salary, wages, bonuses, commissions, or any other kind of employee-based compensation or earnings[2]
Interest and investment income (dividends, gains from the sales of investments, etc.)
Gross self-employment (or “side business”) income[3]
Social Security
Scholarship income[4]
Any other type of income.

Now that you’re thinking about all of your sources of income for the prior year, there are a few that you can scratch off your list, because they don’t count as “income” for tax purposes.

Gift income and other support – While there may be tax implications for the giver of substantial gifts (those exceeding $13,000), there are none for the person receiving the gift.
Inheritance income – Similar to gifts, there may be income tax implications for the estate of the deceased individual, but there are none for the beneficiary of an inheritance.
Loan proceeds – Loan proceeds are considered debt, not income, so cash you receive from any kind of loan is not taxable.

Now that you have a better handle on what counts as “income” for tax purposes, here are the tax filing possibilities that lie before you.

Your income exceeds a certain threshold and you are required to file a tax return.
While your income may be below the applicable thresholds, you should file a tax return because it’s to your advantage to do so.
You are relieved from the burden of filing an income tax return because your income is below the necessary threshold and you don’t have any tax benefits to claim by doing so.

For this article I will focus primarily on Item #1, or determining whether or not you are required to file a tax return.

When are “regular people” required to file a tax return?

If you’re a “regular person” living on your own (meaning you’re no longer a dependent of your parents or a guardian) and you earn most of your money by working, you aren’t required to file a federal income tax return unless your total income for tax purposes exceeds $9,500 (or $19,000 if you’re married).

Example

You’re single, 25 years old, and you just received a $15,000 inheritance from your grandmother. You use this money to go back to college for an advanced degree. You also get a student loan of $10,000. You deposit both the inheritance and the student loan in a savings account and draw upon it as needed for tuition, books, and living expenses. This account earns $300 of interest over the course of the year. Also, to make ends meet, you decide to work part-time while taking classes and make an additional $5,000.

In this case you are not required to file an income tax return because your “income” for the year was only $5,300 ($5,000 wages plus $300 of interest), which is below the tax filing threshold of $9,500 for a single person. Remember, the $15,000 you received as an inheritance and the $10,000 school loan are not considered income for purposes of the tax filing purposes.

Self-employed individuals have strict tax filing requirements

The most stringent requirement for having to file a tax return for regular people has to do with self-employed individuals. For purposes of this test, “self-employed persons” are those who are in business for themselves (which includes having a little “side business”). It also includes those who are “independent contractors,” as well as those who are partners in a partnership. The rule is this: self-employed people must file a tax return if their net earnings from self-employment are $400 or more.

Example

Let’s assume that you’re still that student above, and that your “income” from wages and interest is still $5,300. During the year you notice that students like to wear tee shirts having to do with the school’s sports teams. To make a little extra money, you spend $300 designing and making sports shirts and sell them over the course of the year for $1,000. Thus, your net income from self-employment was $700 ($1,000 less $300).

Your gross income from self-employment ($1,000) is counted as part of your total income form tax purposes, which is now $6,300 ($5,000 wages, $300 interest, and $1,000 of gross self-employment income). That’s still below the $9,500 tax filing threshold for a single person. However, since your net self-employment income of $700 exceeds the $400 threshold, so you are required to file a tax return.

Dependents are not necessarily exempt from filing tax returns

Contrary to the belief of some, there is no automatic tax filing exception for “dependents” solely based on their age.[5] This is a very important concept, so let me say it again in another way. No matter how young someone is (it could be an infant) or how reliant one might be on others (they could be someone that’s 100 years old, living under the care of a relative, unable to do anything for themselves), even if you’re a dependent you have to file income tax returns if you meet any 1 of the 3 following tests.

Your employee-related earned income was more than $5,800.
Your unearned income, or income from interest, dividends, and gains on the sale of investments was more than $950.
Your gross income was EITHER more than the larger of $950 OR your earned income up to $5,500 plus an additional $300.

Of the 3 tests, the third one is definitely the most confusing. It addresses the situation where earned income is below $5,800 and unearned income is below $950, but on a combined basis they exceed the “either/or” threshold outlined above. Where the third test particularly comes into play if you’re a dependent is if you have a decent amount of earnings and you have more than $300 of investment-type income.

Example 1

You earned $4,800 in wages during the year and also received $200 of interest income from a savings account. You do not have to file a tax return because your earned income is less than $5,800, your unearned income is less than $950, and your gross income of $5,000 ($4,800 plus $200) is less than the “either/or” filing threshold amount of $5,100, which is equal to your earned income of $4,800 plus $300.

Example 2

You earned $1,000 in wages during the year, and you also received $350 of interest and investment-type income. While your earned income is less than $5,800 and your unearned income is less than $950, you still have to file a tax return because your gross income of $1,350 ($1,000 plus $350) is greater than the “either/or” filing threshold amount of $1,300, which is equal to your earned income of $1,000 plus $300.

As a note to parents, if you have a child that has a tax filing requirement because their unearned income exceeded the $950 threshold and they have no other sources of income (from wages, for example), you may have the option to simplify things by reporting their income on your return rather than having them file their own. To see of you qualify refer to IRS Publication 17, chapter 30.

Do seniors qualify for any tax filing exemptions?

Given that a substantial number of seniors are among the nation’s millionaires and billionaires, you can be sure that age alone does not exempt anyone from having to file a tax return. But what about seniors at the other end of the financial spectrum, those who are struggling just to make ends meet? Do they get any tax filing breaks beyond those granted to “regular people?” The answer is yes, and it has to do with how Social Security is treated. Specifically, when seniors are evaluating whether their gross income exceeds the tax filing threshold of $9,500 (19,000 for married couples), Social Security does not have to be considered as “income” unless one half of the Social Security benefits plus other gross income (including any tax-exempt interest) is more than $25,000 ($32,000 for married couples).

Example 1

A widow over 65 received $13,000 in Social Security benefits.[6] She also worked a few times a week, making $1,500 over the course of the year. To cover other expenses she drew $1,000 from a regular savings account. The savings account generated $400 of interest income. Given these facts, did the widow meet the $9,500 tax filing requirement? At first it might seem like she did, because her total “cash income” for the year was $15,900. However, upon closer examination the widow does nothave to file a return because her total income for purposes of the tax filing threshold was $8,400, just below the $9,500 filing limit for a single person. This is illustrated as follows.

Example 2

Assume the same facts as above, except that instead of withdrawing $1,000 from a regular savings account to cover living expenses, the widow took it as a distribution from a tax-favored retirement, pension, or individual retirement account (or “IRA”). If that were the case then the widow’s income for purposes of the tax filing threshold would increase from $8,400 to $9,400, which is still below the tax filing limit of $9,500. However, by taking a retirement account distribution the widow will automatically be required to file a tax return (see the section “Other reasons you may have to file an income tax return” below).

Finally, for purposes of the tax filing test, Social Security benefits have to be fully counted as income (meaning you don’t qualify for the 50% exemption) if you’re married filing a separate return (as opposed to a joint return) and you lived together at any point during the tax year.[7]

Advance Earned Income Credit Payments

If you received advance earned income credit payments in your paycheck then you must file a tax return. However, this would only occur if you provided your employer with a completed IRS Form W-5, “Earned Income Credit Advance Payment Certificate.”

To provide just a little more background, the earned income credit is a tax benefit that’s available for qualifying individuals who have earned income, but they don’t make very much money. Those to whom the credit applies often get tax refunds after they file their tax returns (see more on this below). However, rather than wait for a lump sum in the form of a tax refund, some people would rather have more money in each paycheck in the form of advance earned income credits payments (which, again, is the purpose of completing Form 5).

Other reasons you may have to file an income tax return

If you’re still reading this article then it’s probably for 1 of 3 reasons.

You’re captivated by my writing style (unlikely),
You’re very thorough (likely), or
You’re awfully close to not having to file an income tax return.

What I have reviewed so far are the rules that are most likely to cause regular people to have an income tax filing requirement. However, it’s still possible that you have something else going on that will trigger an automatic filing requirement. Here are some of the more likely remaining possibilities.

You owe Social Security and/or Medicare on unreported cash wages such as services or tip income. Does this mean the IRS is going to come crashing through the door and cart off your child if they don’t report Social Security and Medicare taxes on a little bit of babysitting income? As a practical matter, no, probably not (though technically it is reportable for tax purposes). However, if you receive more than a nominal amount of cash from services or tips then this is something you need to pay attention to.
You took taxable distributions from a plan such as an IRA, 401(k), education savings account (or “ESA”), an Archer Medical Savings Account (or “MSA), or some other type of tax-favored account (this is what caught the widow in Example 2 in the “Seniors” section).

If neither of these factors applied to you then you’re at the homestretch, but be aware that there are still some obscure rules remaining that could cause you to have to file a return. These remaining tax filing requirements fall into 3 categories.

“Recapture rules” apply to you – This would occur if you had previously claimed a federal tax benefit, but now you no longer qualify. For example, let’s say (and I’m making this up) that your qualified for a $1,000 Federal tax benefit to complete 2 years of technical training, but you dropped out after the first year. By not completing the second year you could be subject to “recapture rules,” meaning you would have to pay back the Federal government $500 for not completing the second year of your training. So again, think about whether you’ve received any special federal tax benefits for which you may no longer qualify. If that’s the case then recapture rules could potentially apply, but if not then you don’t have anything to worry about.
You owe “alternative minimum tax” – Without getting into a long-winded explanation of the alternative minimum tax (or “AMT”), I will say that it’s extremely unlikely to apply if you fall below the income thresholds listed above.
Household employment taxes – This would only apply to you if you paid $1,000 or more of cash wages to a household employee (such as a gardener or cook), something that would be very unlikely for a regular person who has income below the filing requirement threshold!

If you’ve gone through this entire process and still think you don’t have an income tax filing requirement, the last thing to do is read over the section, “Do I Have To File a Return,” on page 5 in the IRS’s Publication 17, paying particular attention to Table 1-3, “Other Situations When You Must File a 2011 Return.” [8] If you don’t understand something on the table then you first need to apply some common sense. For example, you might not have a clue how the first-time homebuyer’s credit works, but if you didn’t buy a home then you can be sure that it doesn’t apply to you! In summary, for purposes of determining whether you need to file a tax return, it’s often more practical to determine if a tax rule doesn’t apply to you than it is to understand exactly what the rule is and all the details of how it works.

What if you’ve living outside of the United States?

As a final exception, what if you don’t even live in the United States? Do the tax filing requirements still apply to you? The answer is whether you’re herding camels in the Sahara, painting on street corners in Paris, or living in an underground cave on the dark side of the moon, if you’re a U.S. citizen or a green card holder with a heartbeat anywhere in the known universe and you meet any of the requirements above then you have an income tax filing requirement (although you many not necessarily owe any taxes with your return).

You “should” vs. you are “required” to file an income tax return

In conclusion, I want to remind you that the focus of this article has been on helping you determine whether you are required file an income tax return as opposed to whether you should file an income tax return. In other words, if you follow the entire process outlined above and you don’t exceed any of the applicable income thresholds, and none of the automatic filing triggers apply to you, it’s true that you don’t have to file an income tax return. However, it may still be to your advantage to do so.

But why would you want to go to the trouble to file a tax return if you didn’t have to? The main reason is to obtain a tax refund from the government that you would lose if you did not file a tax return. There are 2 common situations where regular people should strongly consider filing a tax return, even when it’s not required.

To get a refund for Federal income taxes deducted from your paycheck over the course of the year when a properly completed tax return will show you didn’t owe any tax at all (or at least you owed less tax than was withheld from your paychecks).
To claim the earned income credit (or “EIC”). This is the Federal tax program referred to above, which is designed to help low-income individuals and families. The EIC is what’s known as a “refundable credit,” meaning that if you qualify, you can get a tax refund from the Federal government even though you didn’t make enough money to owe taxes (or the taxes you do owe are less than the total EIC you’re qualified to claim).

In summary, based on the rules outlined in this article, you might flat out be required to file an income tax return. On the other hand, it may turn out that you’re not required to file a tax return but, as I just pointed out, there are common situations where you should because it’s in your best interest to do so (meaning you’re due a tax refund). And finally, if you don’t have to file a return and you wouldn’t benefit financially from doing so then don’t worry about it, because you’re off the hook![9]

[1] The tax return you file on April 15^th of this year (2019) is to calculate and pay tax on your income from the prior year (2018).

[2] Your employer should report this kind of income to you on a Form W-2 around the end of January each year.

[3] “Gross income” in this case means your total sales, or the full amount of money you took in for your business before taking any expenses into account.

[4] Scholarships can be exempt from taxable income, but a complete analysis is beyond the scope of this article. For more information see IRS Publication 970.

[5] A complete discussion of who qualifies as a “dependent” is beyond the scope of this article. For more information see IRS Publication 17.

[6] In 2018 the average Social Security benefit was $1,081 a month. See http://www.ssa.gov/pressoffice/basicfact.htm

[7] For what it’s worth, if you’re married it’s rarely to your advantage to file separate as opposed to filing a joint return with your spouse, so this situation will only come up in unusual circumstances.

[8] Remember that this article only deals with Federal income tax filing requirements. You need to check separately to see whether or not you are required to file a state income tax return.

[9] This article is intended to be a summary of the tax rules discussed; it is not a substitute for them. For more information see this website’s legal disclaimer.

How do Corporations Work? The Basics Regular People Need to Know

Posted on by Ryan

If you’re going to invest in corporations through stocks, mutual funds, a 401(k) plan, exchange traded funds (ETFs) or some other means, it’s important to understand the basics of how they work. In keeping with that theme, the purpose of this article isn’t to provide an exhaustive, technical explanation of what a corporation is and how one works, but to focus on fundamental principles related to corporations that you need to understand so that you can be a more informed, knowledgeable investor (or even a potential business owner!).

A corporation is a separate legal entity

A corporation is a legal entity that is recognized in the eyes of the law. That is extremely significant, because as a legally recognized entity a corporation has certain rights, such as the right to own property, to open and maintain bank accounts, to hire employees, to protect its rights in court, and so on. With these rights corporations also have responsibilities, such as the responsibility to pay taxes and to otherwise operate within the law. Finally, a corporation’s ongoing status as a separate legal entity is not automatic. The owners of corporations must make annual filings, pay fees, and follow certain legal formalities.

The owners of a corporation have limited liability

One of the greatest benefits and protections of investing through a corporation is that it provides limited liability to its shareholders. In other words, when it comes to the debts or legal liability of a corporation, shareholders are only at risk to the extent of the value of the stock they own. Said another way, individual shareholders are shielded from the debts and liabilities of the corporation they own.

The fact that shareholders have limited liability does not mean that they (or corporate employees) are exempt from prosecution if they engage in criminal activities. In other words, people who own and operate a corporation cannot evade taxes, intentionally dump chemical waste in the town water supply, or engage in fraud and the avoid criminal prosecution simply by hiding behind “the company.” In all such cases the authorities can criminally prosecute those responsible for breaking the law because it’s recognized that you can only put people in prison, not corporations.[1] Following are some practical examples to illustrate how these principles work.

You sell bananas out of your home as an individual. If a customer comes over and slips on a banana peel and is injured then you could personally be sued for damages. In other words, if there was a $200,000 judgment against you then you could stand to lose your savings, home, cars, and other assets.
Assume the same facts as Example #1, except you are the owner of the corporation Deadly Bananas Inc. (“DBI” for short). In that case the clumsy customer could only name the corporation in the lawsuit, not you personally. In the unfortunate event that DBI lost the lawsuit and could not pay the full amount, the clumsy customer could not come after your personal assets such as your home, car, savings, investments, etc.
You sell bananas out of your home as an individual. You place a large order on your personal credit card. If your business were to fail then you would be personally liable for the credit card balance.
Assume the same facts as Example #3, except this time, as the owner of Deadly Bananas Inc., you get a loan from a bank to purchase a large shipment of bananas. If the corporation is later unable to pay back the loan then the bank can seek to recover corporate assets to pay it off, but they cannot lay claim to any of your personal assets (assuming you didn’t sign something personally guaranteeing the loan!).
You steal a massive crate of bananas and purposefully set banana peel traps all over town in an intentional attempt to cause chaos, injury and mayhem. You could be criminally prosecuted for your actions, whether you were acting in your capacity as an individual or as the CEO of DBI.

Corporations have continuity of life

If you run your banana business as an individual, which is technically known as operating a “sole proprietorship,” then the business will die when you do. Granted someone else could step into your shoes and continue to run the same business, but they would be doing business, signing contracts, and developing customer relationships in their name, not yours. On the other hand, if you do business as Deadly Bananas Inc. (you really need to do something about that name) then the corporation will live on as a separate, distinct legal entity as long as it makes the necessary legal filings, pays the appropriate fees, etc. In summary, there are many, many corporations in business today that have long outlived their original owners.

Corporations allow for the easy transfer of ownership

You can easily transfer ownership in a corporation by selling (or giving) the stock in the company to someone else. Because all of the company’s property, contracts and business relationships are already in the name of the corporation, the business can continue to roll on just as it did before; all that’s happened is that the company has a new owner. On the other hand, if someone wanted to by your unincorporated, home-based business, then they would have to do so one asset at a time. And what would you do about liabilities? For example, what if you had a shipment of 10,000 bananas on order? Unless you made special arrangements, that order would still be in your name and you would have to pay for it. But again, if you were incorporated and sold the stock of your company then not only would ownership of the assets transfer with the stock, but responsibility for the debts and other liabilities of the company would transfer as well.

Ownership in corporations can easily be divided

Generally speaking, ownership in a corporation is determined by how many shares you have in the company. The owners of a corporation have the ability to divide their shares, something that provides them with a substantial amount of flexibility in managing the overall structure of the company. Following are some examples to illustrate these principles.

A company has 10 shares outstanding, and you own 7 of them. That means that you own 70% of the company (your 7 shares divided by 10 total shares).
Assuming the same facts in Example #1, you want to sell 1% of the company to 3 different investors. The problem is that each share of the company has an ownership percentage of 10%. The solution? You could increase the total shares outstanding by doing a 10 for 1 (or 10-1) stock split. That would increase the number of shares you own to 70 (7 shares x 10) and the total number of company shares outstanding to 100 (10 shares outstanding x 10). Now you could sell one share (each equal to 1% of the company) to 3 different investors, leaving you with 67 shares.
True or false – By increasing the number of your shares you increase the overall value of the company? The answer is false; stock splits only increase the number of shares outstanding, not the value of the company itself. For example, if a company is worth $100,000 and there are 1,000 shares outstanding then each share is worth $100 ($100,000 divided by 1,000 shares). If the company did a 100 for 1 (or 100-1) stock split then the total shares outstanding would increase to 100,000 (1,000 shares outstanding x 100), but then each share would be worth $1 rather than $100.

Stock can be divided into classes

If all a corporation has is “stock” then it is generally considered to be “Class A common stock.” Each share of Class A common stock has equal voting and economic rights with respect to the company. But other classes of stock can be created which have different voting and economic rights. These principles can be illustrated as follows.

A couple wants to give shares in their company to their children, but they want to maintain control of the management of the company. They create Class B shares and give these to their children. These shares have equal economic rights to the Class A shares held by the parents, so the children can share in the profits of the company just as if they had Class A shares, but the Class B shares do not have voting rights. As a result, the children do not have a say on who will be officers in the company, or in other major decisions such as whether the company will merge, acquire, or be acquired by another company, etc.
The owners of a company want to raise additional funds for expansion, but they don’t want to give away a significant amount profit potential in the process. The owners find a group of investors who want a higher potential investment return than what is offered by interest bearing investments, but they don’t want to take on an excessive amount of risk. In this case the owners of the company could issue “preferred stock” to the investors. Generally speaking, preferred shareholders are first in line when corporate distributions are made and are promised a certain rate, but once they receive an agreed upon amount then the rest of the distributions belong to the Class A shareholders.[2]

Corporations can be “publicly held”

One huge advantage of corporations is that they can “go public,” or be “publicly held.” In other words, corporations can be listed on a public stock exchange such as the NASDAQ or the New York Stock Exchange, which enables the shares of the corporation to be sold to the general public. And what is the significance of a company being publicly traded? It means with a little bit of money and a few clicks of a mouse (or a phone call) that you and I can become part owners of any company listed on a stock exchange: Exxon, Walmart, Google, Bank of America, GE, IBM, just to name a few.

While the process going (and remaining) public is long, complicated, expensive, and involves a tremendous amount of work on the part of a company, it also provides extraordinary opportunities. It gives the owners of the company an opportunity to “cash out,” or to sell some of their stock to the public. And for the company as a whole, it provides a means to raise capital (which means raising money) from a huge pool of investors in order to fund projects that will (hopefully) further drive the growth of the company.

Corporate governance

The corporate organization provides a framework to govern the affairs of a company so that it acts in the best interests of the shareholders while also being a responsible corporate citizen. This is primarily done through the board of directors. The shareholders use their voting rights in the company to elect members to the board who then select a chairman. One of the main responsibilities of the board is to select a chief executive officer (“CEO”) to run the day-to-day operations of the company as well as to monitor that person’s performance. Boards of directors generally grant a degree of latitude to CEOs to run a company according to their best business judgment. However, if the company under-performs for an extended period of time and/or engages in questionable business practices then the board has the power to replace the CEO.

As a practical matter, corporate governance is of greater importance in companies whose stock is widely held by many owners as opposed to a company where stock ownership is concentrated. For example, if a shareholder owns 75% of a company then they can effectively make all of the decisions: they can elect all members of the board, appoint themselves as chairman of the board, and even appoint themselves CEO. In addition, no matter how poorly such a “closely held” company performs, the only way a majority owner can lose their job as CEO is if they fire themselves! On the other hand, at a very large company the CEO may own less than 1% of the outstanding stock. In such cases the CEO’s performance and the relationship they have with the board of directors is more important and takes on a greater degree of formality.

As a shareholder you generally want a board of directors to take a balanced approach in overseeing the affairs of the company. On the one hand, you don’t want them so involved that they interfere with the CEO’s running of the day-to-day operations of the company. On the other hand, you don’t want them to be overly passive either, effectively rubber stamping everything the CEO does and asks for. Such an approach creates an environment where there is a sense of complacency and a lack of accountability, which is a recipe disaster. In summary, an effective board is informed and involved, mostly using its position to influence rather than interfere, but also acting decisively when needed to protect the overall interests of the shareholders.

Corporations do NOT have a life of their own

Following on the concept of corporate governance, one final thing I want to point out is that corporations themselves are not inherently good or evil; they don’t make smart or dumb decisions; they don’t hire or fire people; they are neither charitable nor ruthlessly capitalistic. In fact, corporations don’t make any decisions at all. Only the people who are part of corporations can do that.

Applying this concept to one of the examples above, was it really “Deadly Bananas Inc.” or, more generally, “The Corporation,” that deviously spread banana peels all over town in an attempt to wreak havoc on the general public? Of course not, the corporation itself is simply a set of documents locked away in some filing cabinet. No, the real culprit was the individual(s) at the company who was orchestrating all of the mayhem. While it may sound obvious that, for good or bad, people are always behind the acts of corporations, I point it out because it’s a frequently overlooked concept.

Summary: Corporations provide a powerful means to do business and to raise capital

In reviewing all of the above characteristics of a corporation it becomes much easier to see why they’re a very attractive means to do business.

Separate legal entity – Assets and liabilities can be in the name of the company.
Limited liability – Shareholders are not personally liable for the actions and debts of the company.
Continuity of life – A corporation can exist indefinitely.
Transferability of ownership – Shares of a corporation can be transferred, bought and sold.
Division of shares – Ownership in a corporation can be divided in an infinite number of ways.
Corporate governance – Corporations have formal processes to appoint officers and to oversee the business.

For all of the above reasons, a business organized as a corporation has intrinsic value. In other words, even if a corporation had no assets or liabilities, meaning that it was just a shell company, it would still have value in and of itself because it’s organized in a manner that’s extremely effective for doing business…it just needs someone to pull the switch to get the business going. And it’s for all of these reasons that in terms of assets owned, goods and services produced, and people employed, the corporation is the most dominate form of business in the United States (and the world!).

[1] While this is true, it’s also important to note that a corporation as a separate “person” can get hit with legal, administrative and operating sanctions that can hamper its ability to do business. For example, if an oil company has a major industrial accident then the corporation can be hit with fines and/or lose the right to drill in certain areas. In extreme cases a company can even get shut down altogether.

[2] I will write about preferred stock in more detail at a later time. The point I am trying to illustrate for now is that a corporation’s stock can be divided into classes.

How to Pay Your Bills Online the Right Way

Posted on by Ryan

Being able to quickly, safely, conveniently, and accurately pay bills from home (or anywhere else you can access the Internet) is probably the single biggest advantage of having access to your bank account online. And as far as that goes, I’m NOT a fan of “automatic draft,” but I AM a fan of “paying bills online,” or “online bill pay.” I will now explain the difference between these two payment methods.

Automatic draft

With automatic draft you authorize a company to electronically withdraw money you owe them directly from your account. Companies tout automatic draft as a consumer benefit because it’s convenient (you don’t have to write a check or take any other action) and cost-effective (you don’t have to pay for postage or worry about late fees). While it’s true that automatic draft is both convenient and cost-effective, bear in mind that it’s the companies you deal with that control the amount and timing of the electronic transfer (which is why they love it so much).

So why am I not such a fan of automatic draft? Note that it’s fine if everything goes exactly the way that it should – meaning that you’re charged correctly at the right time. After all, if you owe someone $100 on the 1^st of the month it’s actually nice if that happens without you having to think about it. No, if you’ve got automatic draft and you get poor service and/or you’re incorrectly charged then suddenly you’ve got a different problem: the company already has your money, thus leaving you the burden of getting it back (which puts you at a disadvantage – you always want to be the one holding the money in a financial dispute if at all possible).

Be Careful of Auto Billpay

As an example, my friend Alison once joined a health club that required payment through automatic draft as a condition of membership. We agreed and everything went fine…until she decided to terminate her membership. I remember balancing the bank statement sometime afterwards and seeing a charge from the gym. Somewhat irritated I thought, “Surely that’s the last charge. Didn’t Alison terminate her membership over a month ago?” But the next month’s bank statement came and a monthly charge was still coming through! We then realized this was never going to stop unless we took action. It took several calls to the heath and their accounting office to get things straightened out, and we finally did get our money back, but it took a good deal of effort our part to make that happen.

So to summarize, one of the main drawbacks of automatic draft is that if there’s a problem then you have to make all of the effort to fix the company’s mistakes in order to get your money back. I don’t like that. I would recommending using your credit card. Still, I’m not saying you should never consider using automatic draft. For example, in some cases when paying back a loan you’ll be offered one interest rate, but if you agree to pay it back using automatic draft then you’ll be given a lower rate. So the bottom line is that if a company you’re dealing with is willing to share some of the benefits they receive from getting paid by automatic draft then I believe it’s worth considering. If they’re not – if all they want is an automatic way to take your money at the time of their choosing – then I think you should select the method of payment that’s best for you, and most often that will be to pay your bills online using your bank account (which is sometimes referred to as “online bill pay”).

Paying bills online (or online bill pay)

Like automatic draft, paying bills online using your bank’s website is convenient and cost effective. In addition, it enables you to control how much money you pay, who you pay it to, and when they’ll be paid. This is how it works.

Log on to your bank account (for general information on how to do this if you don’t already have access to your bank account online click here).
Go to the “Pay Bills Online” section (the name will vary by website).
Enter who you want to pay (if the payee is not already in your bank’s records then you may have to input the information manually the first time you make a payment).
Decide which account you want the money to come from (it could be from a checking or a savings account you have at the bank).
Enter how much you want to pay them.
Enter the date you want them to be paid.

After you’ve input this information then one of the following two things will happen.

If the payee is set up for electronic payments at your bank then the money will be transferred from your account to the payee’s account on the date you selected.
If your payee is not set up for electronic payments then on the date you selected your bank will automatically print a check and mail it to the payee.

Note that paying bills online is slightly more work than automatic draft because you do have to take some action: you have to log onto your account and follow the steps above. However, it still saves you postage and the time it takes to write checks (just like automatic draft). But even more than that, paying your bills online enables you to take control of your hard earned money by determining how much you will pay, whoyou pay it to and when they’ll be paid.

6 Benefits of Managing Your Bank Accounts Online

Posted on by Ryan

By managing your banking needs online to the extent possible you can cut down on the number of inconvenient, time-consuming trips that you would otherwise have to make to the bank. Following are some specific and useful things relating to your bank accounts that you can do online.

#1 – Check account balances

You can check the current balance of your checking and savings accounts online. This is useful because it enables you to see whether certain charges (such as a recent purchase) have hit your account and whether or not the amounts are accurate. It also enables you to see whether checks you’ve deposited have cleared.

In addition, if you have a credit card issued by the bank, you can also review your credit card activity online.[1] Again, this is very useful because it enables you to verify if your credit card transactions have processed and whether or not they’re accurate. It also gives you the ability to monitor your account as often as you like to ensure that no unauthorized charges have been made.

#2 – View check images

By accessing your account online you can view (and print) images of checks you’ve written. This comes in very handy if you lose a check carbon and you can’t remember who the check was to or how much it was for. To give you an example of something I’ve done many times, say that you’re organizing the check carbons for checks your recently written as part of updating your checking account balance. You’ve got check carbons for checks 1001 through 1010, but the carbon for check 1008 is missing. So what does that mean? Did you void check 1008 or did you actually write it? You can solve the mystery by accessing your account online and looking up check 1008. If it hasn’t cleared after a period of time you most likely voided it, but if it did then you should be able to see it online, even to the point of being able to print out a copy for your records if necessary!

#3 – Pay bills online

The ability to pay your bills electronically is a HUGE benefit of doing your banking online.

#4 – Transfer money electronically

Another convenient feature of online banking is the ability to transfer money electronically between your financial accounts. For example, you can transfer money between:

A checking account and a savings account at the same bank.
A checking account and a savings account at a different bank.[2]
A checking (or savings) account and an investment account with another financial institution (which gives you a convenient way both to invest and to draw funds from your investments as needed).

Transferring money from one account to another at the same bank or financial institution is generally very straightforward. However, to link accounts at two different banks or financial institutions takes a little more work. To do so, log onto your bank or financial institution’s website, go to the “Electronic Funds Transfer” section, (the name will vary by website) and follow the applicable instructions.[3] Is the process of figuring out how to transfer money between your financial accounts a bit of a pain? Sure, but you’ll reap the rewards of your time and effort for doing so many times over. Here are some examples of how.

Each time you get paid you can transfer money to your savings account. It can either be a fixed amount each paycheck, or you can vary it based on your goals and the amount of extra money that you have. Likewise, if your checking account is getting low then you can bolster it by transferring money to it from your savings account.
If you’re in your working years, you can set up your primary checking account to safely, conveniently and consistently transfer money to your investment account to save for retirement or other long-term goals.
If you’re retired, you can transfer a set amount each month from your investment account to your checking account as a living allowance. In addition, you can transfer additional money to your checking account for whatever purpose at any time (assuming you’ve saved and have the additional funds!).

Again, prior to online banking, doing any of the above transfers was a real pain. It required you to go in person to your bank or financial institution or to do everything by mail. But with the ability to do these kinds of transfers online, you can move your money to where it needs to be in a manner that’s quick, safe, time-efficient and easy to track.

#5 – Stop payment on a check

If necessary for whatever reason, you can put a “stop payment” on a check in order to void it before it’s deposited or cashed. You used to have to make a trip to the bank in person to stop payment on a check, losing valuable time in the process (because for a stop payment to work it has to be done BEFORE a check clears!). However, you now have the ability to stop payment on a check through online banking.

#6 – Communicate with your bank

Getting answers to short, specific questions used to require a time-consuming trip to the bank to talk to a service representative or to navigate through an impersonal (and often overly-complicated and unhelpful) phone menu. Now many banks provide you with the ability to get answers to specific questions online from a service representative via email. If you’re not able to successfully get answers in this way then, of course, you always have the option to go to your bank in person or call their customer service line. But if you’re able to resolve your questions online then that’s so much more convenient!

Invest the time to learn how to access and effectively use your bank accounts online

Online banking is really about investing. How is that? Remember, effective investing means making a sacrifice now in order to reap far greater benefits in the future. In this case, if you take the time to learn how to access and effectively use the online features of your bank accounts (which not only include the items above, but even more) then you will reap great dividends in the future in terms of saving time, stress and money (no more stamps for bills, for example!).

So, if you don’t already have an online account with your bank or financial institution, follow the instructions on their home page to set one up. If you have any trouble doing so then find their phone number in the “Contact Information” section of their website and talk with someone with their technical services group. If that doesn’t work then, in order to obtain all of the benefits of online account access, it’s well worth the effort to make a trip to the bank in person to get help directly from a service representative.

[1] If your card was issued by a financial institution other than your bank then you’ll have to log on to their website to view your credit card activity.

[2] Not all banks provide this service, but an example of one that does is ING Direct.

[3] If you don’t already have an online account with your bank or financial institution, follow the instructions on their home page to set one up. If you have any trouble doing so then find their contact information on the website and consult with their technical services group. If that doesn’t work then, in order to get online account access, it’s well worth the investment of time to make a trip in person to get help directly from a service representative.