Approach your windfalls–and tax refunds–with a plan
In my home, unexpected money is known as a “hit from the sky.”
It simply falls from the heavens and lands in your lap.
But my household is different than most, since my wife is a free-lance journalist and windfalls sometimes arrive in the form of extra assignments we had not counted on.
In households where the income stream is a little more steady, there are typically only three types of hits from the sky: gifts or inheritances, unexpected bonuses and tax refunds.
The average tax refund this year will be about $1,200, according to the Commission on Saving and Investment in America. That’s a pretty nice boost for the pocketbook. But like any sum of money that suddenly finds its way to you, it also represents a significant opportunity.
This isn’t like finding five bucks that you left in an old pair of blue jeans; it’s a nice chunk of change. What you do with it requires some serious thought.
If you are lucky enough to have the tax gods smile on you with a refund this year, here are the things you might want to consider doing with your windfall.
– Pay down your debt. The best way to look at sudden money is in terms of what it can do for the rest of your spending habits.
If you have been carrying debt without being able to pay it off, a sudden chunk of money puts some octane into your efforts. The more you reduce your debt, the less interest it accrues each month. Even if a lump-sum payment won’t reduce your debt to zero, it will cut into the amount of finance charges you accrue every month, and that means your regular payments will go a little further.
This will help accelerate the process by which your regular monthly payments cut into your debt burden.
– Save it. Sure, this sounds like your mother talking, but face the fact that as long as you have made ends meet before this money arrived, there should be no compelling reason to spend it. A study by the Competitiveness Policy Council shows that only one-third of the 70 million Americans who expect to receive a tax refund plan to save their money. On the whole, Americans consume about 95 percent of their disposable income, which means that most of us are saving too little–especially when you consider that one wholly inadequate rule of thumb is that saving 10 percent of your income will create a sufficient nest egg. (Many experts believe you will need closer to 20 percent.)
Saving the tax refund–or any sudden money–is easier than taking a cut from your paycheck for one reason: Presumably, you never missed it in the first place.
Meanwhile, the average tax refund goes a long way to making the annual allowable contribution to an individual retirement account, or can be a nice little boost to a college or retirement savings program.
If you receive the average refund this year, invest it and get just a 6 percent return, your money will double in 12 years and will be worth nearly $7,000 after 30 years. That same $1,200 invested with a 10 percent annual rate of return–roughly the long-term return of the stock market–would grow to almost $21,000 if left untouched for 30 years.
Saving your tax refund is particularly critical if you planned to actually get money back. Your refund represents take-home pay that you gave up, interest free, throughout the work year; if you overwithheld to force yourself to amass the savings, then make sure the money reaches its destination. (And then adjust your tax withholdings so that you get the extra take-home pay in your check and can invest it regularly.)
– If you earmark it for something, get what you planned for. Many people use tax refunds as forced savings, planning a big purchase or a trip for when the check arrives. That’s a great idea, provided that the money actually goes there.
It’s easy to throw the money into your general cash flow, pay the bills aggressively and then find your surprise money evaporated when it was needed the most.
If you earmark your savings, or if you can plan for a small inheritance or an extra project at work, don’t cash the check until you are ready to spend the money. Give yourself your just rewards without affecting your regular cash-flow patterns.
Be realistic about your expectations. Your money can’t go in two directions at once, so prioritize your plans. If your windfall is smaller than expected, you may have to make a sacrifice.
There is nothing wrong with spending the money, but there is everything wrong with “blowing it” and winding up on the same old track a week after your refund money is gone. Worse yet is overspending your surprise money, where your plans outstrip the money that actually arrives and you wind up in the hole.
– Give some to charity. Any time you get a windfall, consider your good fortune and those who aren’t so lucky. It may seem incongruous to get a windfall and then give some of it away, but it’s a great way to guarantee that some good comes from your good fortune.
Besides, every now and then our lives should be guided by something more than spending and saving our own money.
And if that’s not enough, remember that if you give a portion of your tax refund, you are simply continuing the process. Your donation to a qualified charity is tax-deductible, which will help you get another refund check next year.
– Get financial help. It’s not that you need an adviser to help with the $1,200 average refund or with whatever bonus money comes home from work. It’s that you may need help getting your financial life in order.
If you need an adviser and yet don’t want to pay for the services out of your current cash flow–or believe you can’t afford an adviser on your regular cash flow–then your good fortune may be just the ticket needed for getting assistance.
And remember, too, that financial advisers come in many forms and styles. It’s not just about picking investments, but about managing cash flow and maximizing your opportunities.
– Budget the money and blend the uses. Most people think of budgeting as a chore, especially when it involves all of the money earned and spent in an average day, week, month or year.
But since your windfall is a finite amount of money, you can budget your desires and see that the process really isn’t so difficult.
