What Should I Do with My Tax Refund?
Topics: Financial Plan, Emergency Savings, Debt Reduction, Investments, Roth Conversion, Solo 401K
In my last post (Covid-19 Update (Part 2): How Do I Manage/Find Cash in a Crisis?) we talked about the need for cash in a crisis, so maybe your tax refund can provide a timely buffer if your financial situation has been negatively affected by recent events. If your income remains steady and your cash position is solid, you might be thinking about how to best use the dollars from your tax refund.
The amount may not even be that significant, but usually every bit helps. And don’t feel bad if you don’t get a refund and must pay taxes. That just means you didn’t give the government an interest free loan over the past year. If you find you owe a large tax amount or get a large refund, you might consider adjusting your tax withholding to even out your income. If you expect a hefty tax burden, look to save money before taxes with a 401K or other personal savings vehicle such as an Individual Retirement Account (IRA). If you anticipate a large refund and/or have a lower income year, you might consider a Roth conversion (more later).
While this question is about a tax refund, it’s really more about what you could do if you had a sudden increase in income – a tax refund, a one-time bonus or inheritance. Or maybe you just won the lottery! The inclination is to spend such a windfall. Many people will find it easier to justify a one-time purchase or going on a trip or completing a project around the house with their new-found wealth. While these will certainly be an appreciated boost to the economy, I would personally try to plan ahead - boring I know, but a plan can help make sure some of your new dollars are allotted to the future. Of course, that new patio or the bathroom remodel may ultimately increase the value of your house, which is beneficial for the long-term. Not to mention your personal enjoyment. I get it – it’s not always a financial decision!
So besides spending, what is the best use of your spare dollars? Here are 4 Thoughts:
- Create a Financial Plan
- Beef up emergency savings
- Invest it
- Reduce debt
Before we get into the details:
- If you’re looking to cut costs our Cash Flow Management service can help, and I believe it can pay for itself. Or you can sign up for Free expense tracking as well.
- If you are in need of budgeting assistance, check out our post (How Do I Get Out of Credit Card Debt and Start a Budget?)
- If you’re curious about your net worth, ready to start your Financial Plan or outsource your Household CFO duties, start here by creating your own Right Capital login.
- If you have other needs or questions about your finances, please email me: email@example.com.
On a personal note
In spite of more kids, greater tax deductions and increased itemizing, we generally pay taxes this time of year, but have become okay with that as we try to manage withholdings. That changed when starting a business, and modest refunds will probably continue near-term as business profits will go to the Solo 401K I set up for myself. This is all part of a plan to strategically “manage my taxes”, not just pay blindly. Expecting a refund again for 2019 taxes, we further tried managing taxes this past year by rolling over traditional IRA funds into a Roth IRA, which would ultimately reduce our refund (or increase taxes paid), but improve our tax situation long-term as Roth IRAs grow tax-free. Most people do get a refund with the positive changes in the tax code (without even itemizing!), and no doubt we will spend some of ours, but of course we will be looking for that next investment opportunity as well!
So onto our 4 Thoughts:
Create a Financial Plan
This is ultimately an advertisement (like all my blog posts) to get your financial house in order, specifically invest in a Financial Plan. Also of note is that our Financial Planning services are included when we manage your portfolio as part of our Asset Management services. A Financial Plan can help determine the strategy for what to do with excess cash, which is why you might need a plan before proceeding down the items on this list (savings, debt, investments). We can evaluate your expenses to determine appropriate Emergency Savings levels, and then help optimize both your debt and your investments. We can even look at next year’s tax strategy if applicable.
This is a necessity in life. The statistics are abundant about Americans inability to come up with cash in an emergency. The most recent sign is the nearly 2,000% increase in borrowers seeking relief from their mortgage payments. Kudos for being able to save for a house but if you don’t have enough cash to cover your next mortgage payment, I’m not sure you should have a house in the first place. The rule of thumb is 3-6 months of all your expenses, so if you aren’t there, and you get a lump sum back from the government, I suggest building up your emergency reserves to avoid the next catastrophe.
As you may have guessed, this depends on what kind of debt. If you have high-interest credit card debt, start paying that off. That’s probably as important as building up your Emergency Savings. If credit card debt is ongoing, you should work to change your mindset around money. Sorry to be blunt. Sacrifice today for the future. Forgo instant gratification for the satisfaction of a comfortable and timely retirement.
However, if you’re close to paying off other forms of debt, like a car loan or student loans, then that can be an option as well. As for that primary mortgage, putting $1,000 toward a $100,000 mortgage balance does almost nothing. Especially if you have a low interest rate. Don’t forget your mortgage interest is deductible on your tax return. Student loan debt is as well but is limited in amount and to certain income levels.
This is an extremely broad topic, but obviously a favorite of mine. You’re thinking about your future if you put new funds into a retirement account. Though you can’t put these funds directly into an employer’s 401K plan, it may give enough cushion to allow you to increase your 401K contribution rate and get a higher employer-match (which we note is a 100% return on investment). Putting into an IRA can provide similar tax benefits.
The ongoing stock market volatility has provided an opportunity to buy stock at a discount to recent highs, but there are many investment options, so look for the option that provides your best return. We should definitely talk about your best options!
So in summary, using spare dollars to create a Financial Plan will ultimately help you assure your savings rate is adequate, diversify your investments and optimize your debt. Now is a great time to formulate your Financial Plan – please send an email: firstname.lastname@example.org.
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If you or someone you know has any financial-related questions, I would love to have a conversation, so please feel free to reach out: email@example.com.
Best wishes on your financial path!
This post was created by Matt Beeby, the Founder of MHB Advisory Services. Matt has been working in Financial Services and investing in real estate since 2005, though his investment experience spans nearly two decades. He is a Christ follower, active in both his church and his neighborhood association. Matt enjoys sports and family time. Read more about Matt on his website bio.
- Information contained in this document is for informational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any product or security.
- This information is believed to be accurate and should not be considered tax or legal advice.
- Please consult tax or legal professionals for such advice and be sure to consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed.
- Investments involve risk and are not guaranteed to appreciate, and past performance is not indicative of future results.