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Putting Your Tax Refund to Work
Although it's tempting, don't immediately blow your tax refund on a European vacation or a new plasma screen television.
Instead, one smart thing to do is to use the refund to pay down your high-interest credit card debt. Or you could put the money toward an emergency cash fund, usually six months' worth of living expenses, which can help you weather economic uncertainties. Yet another possibility is to invest the refund for long-term goals such as your retirement or college education for your children or grandchildren.
This same advice applies to a bonus, inheritance or any unexpected lump sum of money throughout the year.
Let's take a closer look at the possibilities:
Pay down high-interest debt
About 44% of American families have credit card balances, and this debt can cost them at least 12% a year in interest payments, according to the Federal Reserve. So it's a worthwhile idea to use the refund to pay off as much of this high-interest debt as possible.
To get started, list all your loans, balances and corresponding interest rates. Then begin by paying off the highest interest rate loans first. Interest on home-equity loans is deductible, making those debts cheaper than they look, and therefore a lower priority.
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Start an emergency cash fund
Most financial professionals recommend that you set up a separate "rainy day" account of three to six months of living expenses to tide you over in case of a layoff or unforeseen health problem that isn't covered by insurance.
Most people already have a checking account and a savings account, but many advisers suggest you open a separate "emergency" account so you are less likely to deplete the fund by writing little checks for non-emergency expenses.
Invest for your retirement
If you decide to invest the refund for long-term goals, most financial professionals say that you should first concentrate on putting aside money for your own retirement years. It makes sense to make this a high priority. Your son or daughter can work part-time, earn a scholarship or borrow money to pay for a college education, but you can't take out a loan to pay for your retirement.
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Employer's plan: Start by participating in or increasing your contributions to your employer's 401(k), 403(b) or 457 plan. You can make pretax contributions for 2007 of as much as $15,500 — or $20,500 if you will be age 50 or older at year-end. With these plans, employees get the benefits of tax-deferred growth and excluding their contributions from taxable income until they take the money out.
Even though many employers match part or all of an employee's contribution, many people miss out on these contributions by not participating. Almost one-fifth of eligible employees don't have any money in their plan, says the Profit Sharing/401(k) Council of America.
Talk to your retirement plan representative to see if you can start or increase your 401(k) or other salary deferral plan contribution in the remaining months of the year. If necessary, you can use the refund to make up for the reduction in your take-home pay when your contribution begins or increases.
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IRA: If you are taking maximum advantage of your retirement savings plan at work (or if your employer doesn't offer one), you could invest in a Traditional or Roth Individual Retirement Account (IRA). You can contribute up to $4,000 for 2007. If you are age 50 or older, you can make a "catch up" contribution and contribute a total of $5,000.
If you invest now, rather than waiting for the deadline on April 15, 2008, you can have that money working and compounding for you over a longer period of time. Of course, investing early doesn't guarantee a profit or protect against a loss.
Your income will be a factor in your decision as to whether you can invest in a Roth IRA or a Traditional IRA. You may or may not be able to deduct your contributions, based on your income and your (or your spouse's) participation in an employer's retirement plan.
The earnings on Traditional IRA accounts grow tax-deferred until you take them out, at which time you pay ordinary income taxes on the withdrawals. With a Roth IRA, you can't deduct the contributions from your taxes but the earnings grow tax free. Moreover, if you make qualified withdrawals after age 59 1/2, you don't have to pay income taxes.
For more specific information about which IRA is best for you, consult with your Lincoln
Investment financial representative.
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Invest for your child's college education
After you've focused on building up your own retirement, it's time to look at ways to help fund your children's or grandchildren's college savings plan. There are a number of approaches you could take.
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529 College Savings Plans: One way is to invest in a 529 College Savings Plan. These plans are sponsored by individual states. Most plans are open to investors from any state, but some states provide additional tax benefits to residents who use their own state plans.
Participation in a 529 College Savings Plan (529 Plan) does not guarantee that
contributions and investment return, if any, will be adequate to cover future tuition and
other higher education expenses or that a beneficiary will be admitted to or permitted to
continue to attend an institution of higher education. Contributors to the program assume
all investment risk, including potential loss of principal and liability for penalties such as
those levied for non-educational withdrawals. Depending upon the laws of the
customer's home state, favorable state tax treatment for investing in a 529 Plan may be
limited to investments made in a 529 Plan offered by the customer's home state. Assets
in a 529 Plan can potentially reduce the beneficiary's ability to qualify for some forms of
college financial aid. Current tax law, which exempts earnings on qualified withdrawals
from federal income taxes, expires on 12/31/10, unless extended by Congress.
Customers should consult their tax advisor about any state tax consequences of the
investment. For more complete information, including a description of fees, expenses
and risks, see the offering statement or program description.
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Coverdell Education Savings Accounts: These are another effective way to save for college, elementary or secondary school. Contributions are limited to $2,000 a year per beneficiary and a person's ability to contribute is limited by certain income requirements.
Contributions are phased out as an individual's adjusted gross income increases from $95,000 to $110,000 — and from $190,000 to $220,000 for married couples filing jointly. All contributions are after-tax and are not deductible. Earnings can grow free from tax. Withdrawals for qualified elementary, secondary* and higher education expenses are free from federal tax.
*The tax-free advantage for elementary and secondary education continues only through 2010 unless Congress extends these benefits.
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UGMA/UTMA: UGMA/UTMA accounts are a third option. Though their names sound intimidating, the Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA) can help parents working to save for their children's future. The funds can be used for anything that benefits the child — not just education.
Anyone can give up to $11,000 per child each year free of gift tax consequences ($22,000 for married couples). Contributions are made with after-tax dollars and are not deductible. Your child doesn't gain control of the money until he or she reaches the age of majority (18 or 21 in most states).
For more details, consult your Lincoln Investment financial representative.
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Think about a regular taxable mutual fund investment account
If you're already contributing the maximum amount to your retirement accounts and have begun a college savings plan for your children or grandchildren, investing in a regular taxable mutual fund account could be another good way to help your money grow.
So rejoice when your income tax refund check arrives in the mail or is deposited in your bank account over the Internet. But seriously consider using it as a way to reduce your high-interest rate debt, build up an emergency cash cushion or invest for your retirement or children's college education.
None of the information on this website should be considered tax or legal advice. You should consult your legal or tax advisor for information concerning your individual situation. |
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