Estate Planning

Five Smart Ways to Use Your Tax Refund

About three in four Americans filing a tax return get a refund, according to the IRS, with an average refund of $3,000. While it may feel great to get that big check from the government, if your refund is over $1,000 you might consider it a sign you should take a look at your overall financial strategy. There must be a better way to use that money all year than letting the government borrow it for free.

Many people view this as a form of forced savings, which can be helpful, and because it’s sort of “found money” the refund may be spent on vacations or a new television. Presumably, you’re reading this because you want to think more strategically about your refund. So, let’s attack this two ways. First, let’s talk about what to do with this year’s refund, and then we can explore how to change things so that you get to keep your money this year.

Here are five smart ways to use your tax refund:

  • Max Out Your IRA. Both the government and corporate America have basically shifted the burden of retirement savings to the individual. The lack of availability of traditional pension plans and the possibility of reduced Social Security benefits requires each individual to strategize properly for his or her own retirement. Thus, if you meet the eligibility requirements to fund a Traditional IRA, you should do so up to the maximum. Alternatively, depending upon your other sources of income, you should also consider funding a Roth IRA to provide a source of tax free income during retirement.
  • Boost Your Emergency Savings Fund. As a rule of thumb, every individual should have easily accessible savings equal to about six months of expenses. Based upon the current economic environment, anytime you can add to your emergency savings, you should.
  • Pay Down Debt. Credit cards and other forms of consumer credit can charge 14 to 18 percent interest annually, an almost crushing level of interest when you consider that interest rates on savings accounts are hovering at around 0.25 percent and even the long-term annual return in the stock market is around six to seven percent.1 One of the best things you can do with your money is to pay down your debt and start paying cash for your purchases.
  • Start Investing. The sooner you begin investing the better off you are, because this gives you the freedom to invest for the long-term. Using your tax refund could enable you to open an account and encourage you to allocate some funds each month to the account as well during the calendar year.
  • Invest in Your Business. Depending upon your personal needs, investing all or a portion of your tax refund in your business may be beneficial. The funds may be used to reduce business debt, enable capital improvements, establish an employee benefit program such as a 162 Bonus Arrangement or retirement plan, purchase equipment, etc.

There are many other smart ways to use your tax refund: Establishing or funding a 529 Plan or Coverdell Education Savings Account for a child or grandchild; paying a portion of a grandchild’s tuition; allocating the refund to a life insurance premium; paying medical expenses of a parent or grandparent; make a gift to a trust for legacy planning; and/or establish a new business venture.

Everyone’s situation is different, so talk to your tax advisor about which choice might work best for you. I’ve always approached my own finances by viewing my options as a pyramid. At the bottom of the pyramid is financial independence. The middle of the pyramid is family legacy, and the top of the pyramid is social capital. The foundation of everything is financial independence — you have to start with taking care of yourself. That means you’re putting away enough for your retirement and your medical needs are taken care of. For the family legacy, that’s where you get into saving for your children’s education and making sure you have life insurance so that your family’s taken care of if you die prematurely. For social capital, this is where you give back to the community through contributions to your alma mater, to your house of worship, to a local or national charity, to whatever is important to you.

So, we’ve dealt with this year’s refund. What about next year? Is there a way you can keep more of your money now, instead of giving the government an interest free loan? It’s a balancing act.

The first step is to ask: How much cash flow do you need to meet your requirements and make sure that you are funding your retirement, your health savings account? You should also be saving a little bit each month, anyway, not simply just relying on that check. Then you take a look, at your withholdings and quarterly estimated taxes if applicable. I don’t think people spend a lot of time thinking about their withholdings. They fill out their W-4 when they first get hired and never think about it again. But it is something that should get attention — your circumstances may have changed since you first set up your withholdings. Sit with your accountant and run some numbers to determine the best approach. Obviously, nobody likes to write a check to the government, but if you have to write a small check, that’s better than getting a giant check back.

The problem is that people tend to spend first and save only what’s left at the end, and there’s rarely very much left at the end, which is why so many people end up relying on the forced savings of having too much money withheld for their taxes. The question is: Can you be disciplined about your finances, setting up a pre-planned amount that goes into a savings account before the rest of the paycheck goes to your checking account? If you can, then you may discover the joys of keeping your money for yourself instead of loaning it to the government interest free.

Please note: This information should not be construed as tax or legal advice applicable to each individual. Please consult a qualified tax or legal advisor regarding your individual circumstances.

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This post is for informational purposes only and should not be considered as specific financial, legal or tax advice. Depending on your individual circumstances, the strategies discussed in this post may not be appropriate for your client’s situation. All opinions expressed in this post are solely those of the author and do not necessarily reflect the opinions of Penn Mutual, its affiliates or employees. The information in this material is not intended as tax or legal advice. Always consult your legal or tax professionals for specific information regarding your individual situation.

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