Smart Ways to Use Your Tax Refund

Tax season is upon us. Over the coming weeks, millions of Americans will submit their 1040s and other documents to the IRS. Some will have to pony up for their tax bill. But for those of us lucky enough to be getting a refund (small or large), what’s the best thing to do with it?

That depends on your situation. All You lists 10 smart ways to spend your tax refund:

1. Set up a rainy-day fund

2. Fight credit card debt

3. Refinance your home

4. Pad your nest egg

5. Go green to save

6. Put it away for college

7. Splurge — smartly

8. Invest in your health

9. Take a class

10. Give it away

These are all great options for dealing with your refund. I’m sure if you got creative you could think of other uses as well.

For the beginner just starting out, I recommend setting aside $1,000 in an emergency fund before you do anything else. Don’t do anything crazy with that money — just park it in an online savings account. This is so important because unexpected expenses pop up in life. Cars break down. You or a child could get sick and incur hospital bills. You might be faced with unemployment one day. Drawing on your emergency fund in these situations is a much better option than relying on credit cards with 15% interest or more. Read more about building an emergency fund here.

A couple years ago my wife and I received a pretty nice size refund that we weren’t expecting. It was fairly early in our marriage and we were just starting to get our finances in order. We knew the importance of having an emergency fund, but a costly car repair months earlier all but wiped out our savings. So that year we used our refund to rebuild our emergency fund.

If you already have a sizable emergency fund, focus on paying off high-interest debt. This includes credit cards and private student loans. Only after you have done this should you consider any of the other options above.

I like the idea of investing in yourself by taking a class or improving your health. The article mentions joining a gym, but I think a good pair of running shoes is a better buy. The outdoors is all the gym you need if you’re creative.

Some of these options might not sound particularly exotic — paying off credit card debt, for example, isn’t the most glamorous thing to do. But it will put you in a much better position. Success in personal finance often requires you to choose the “dull” option even if you are tempted otherwise.

This year we’re also getting a refund, but it will be somewhat smaller than prior years. I plan to use it to open a Roth IRA at Vanguard. Whatever you do with your refund, use it as an opportunity to better yourself or your situation.

Photo by JD Hancock

Set It and Forget It: Target-Date Funds for Retirement

We’ve established that the Roth IRA is the best way to save for retirement. Now that we have a “house” (the Roth), what “furniture” (investment funds) should we put inside?

One type of fund that has grown tremendously in the last 5 to 10 years is the target retirement fund. These funds are designed to give you the appropriate mix of stocks, bonds, ETFs (exchange traded funds) and mutual funds based on the number of years until your retirement.

Most investment companies have target funds in five-year increments. Based on your age and the number of years you plan to remain in the workforce, select the fund closest to the year you plan to retire. For example, if you plan to retire in 30 years (2042), choose the 2040 fund.

These accounts are extremely easy to set up — just put all of your money into the fund and the fund manager will take care of the individual investment mix. They offer adequate diversification across a variety of industries and require very little monitoring. My favorite company to use is Vanguard, which has very low fees relative to others in the industry (0.19% vs 1.5% or higher).

These funds are extremely low-maintenance. At the outset, when you’re young and have perhaps 35 to 40 years until you stop working, they are set up to invest heavily in stock-type choices. The fund I use, the Vanguard Target Retirement 2050 Fund, invests in about 90% stocks and 10% bonds at the time of this writing. The mix of funds automatically turns more conservative by increasing the ratio of bonds to stocks as you approach retirement age.

A target retirement fund inside a Roth IRA is an efficient, low-cost way to save for retirement. The strategy is very simple: set it and forget it. You can open a Roth account for as little as $1,000. Set one up today and start putting money away for your future.

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How much should you save for retirement?

Retirement is a subject a lot of us don’t like to think about. Younger Americans believe that because of their age they don’t have to start thinking about retirement until decades later. It’s far off into “the future.” The truth is though, most of us will decide to stop working one day. Thanks to advances in medicine, our life expectancy is increasing and more people are living into their 80s and 90s. Thus, it’s safe to say that the retirement stage of our lives could last 20 to 30 years or more.

So how much should you put away for retirement? According to U.S. News, there are several factors in deciding how much to contribute to a 401(k):

  • Maximum allowable amount
  • Matching level
  • Default rate
  • Saver’s credit limit
  • A personal calculation
  • Professional recommendations
  • Do what you can

Maxing out a 401(k) (investing $17,000 in 2012) may not be possible for everyone. If you’re in this group, they have a good recommendation:

If you can’t max out your 401(k), try to contribute enough to get the maximum possible 401(k) match. The most common 401(k) match formula is 50 cents for each dollar contributed up to 6 percent of pay. Under this match formula, an employee earning $50,000 who saves $3,000 in the 401(k) plan will get another $1,500 from his or her employer as a matching contribution.

If you’re not getting the match, you’re leaving $1,500 on the table!

Enrollment in 401(k) plans varies by employer. When you start a new job, your employer may automatically enroll you in their 401(k) plan. Pay attention to what your contribution percent is and whether it increases over time. On the other hand, you may have to choose to opt-in to the plan. In this case, you can choose what percent of your income to set aside. If your financial situation changes, you should be able to change your contribution percentage each quarter.

When you file your taxes, you may be eligible for the savers tax credit based on your income. Along with the company match, this provides another incentive to save for retirement.

It’s always a good idea to come up with your own estimate for how much money you’ll need during retirement. A good rule of thumb is that you’ll need at least 80 percent of your current income to live comfortably in retirement. This estimate will change over the course of your working life assuming your income increases.

If the thought of coming up with an estimate overwhelms you, enlist a fee-only financial planner to help. Either way, the article makes a good recommendation:

On average, 401(k) plan sponsors say employees should be saving 12 percent of their pay including employer contributions over their entire working career in order to provide adequate income during retirement.

I think 12 percent is a good number, but over time this should increase to 15 and even 20 percent of your income. Besides, investing in a 401(k) is a good way to reduce your current tax burden. 🙂