Being Wise with Your Windfall: Tips for Using Your Tax Refund

coins-currency-investment-insuranceIf you’re expecting a hefty tax refund this year, you may, like many people, intend to have some fun with your windfall. After all, it’s your money and you worked hard for it. There’s nothing wrong with heading out for some much-needed vacation time or buying a big gas grill for those summer cookouts. As tempting as that may sound, before you buy anything, consider the benefits of using a tax refund to better your financial situation.

Savings

If you’re among the many Americans who lack a rainy-day fund, think about setting all or part of your refund aside in an interest-bearing savings account. You never know when the transmission in your car may give out or an aging roof might start to leak. These are costly repairs, and the average American is unprepared for them; in fact, just 39 percent of Americans are capable of covering an emergency costing $1,000 or more. If you lack at least three months worth of emergency savings, that tax refund may serve you better as an emergency financial reserve.

If your roof could use some work, repairing it is an excellent use for a tax refund. You’ll head off more serious problems resulting from neglect somewhere down the line. But be diligent in looking for a qualified roofing contractor, and ask yourself several questions to determine what, exactly, you need. Check with the Better Business Bureau to make sure your contractor is accredited, and check out the BBB website for complaints or any disputes or scams a company may have been involved in, as well as tips regarding what to look out for.

Pay Down Debt

Debt is a fact of life for most Americans. If you struggle with credit card debt or are behind on the mortgage, your refund can help you out. Paying off debt is a smart move because the high-interest merry-go-round can be very hard to get off when you’re just managing it by paying the minimum every month. That can take you years to pay off even a moderate amount.

College Savings

According to CNN Money, most Americans can expect to pay about $57,000 for a degree at a public college, and more than $100,000 at a private institution. That’s a lot of money for anyone. Why not use your refund to open a 529 or Coverdell education savings account? And investing in your state’s 529 plan may result in a nice state income tax deduction. However, beware of using the money for unqualified purposes, which can earn you a 10 percent penalty.

Roth IRA

A Roth IRA lets you stash money away that becomes tax-free after age 59.5 as long as it’s been open for at least five years. You can contribute to it as you wish and withdraw the sum of your contributions without being hit with a tax or penalty. Your Roth earnings can be used tax-free for education expenses or for a first-time home purchase.

Invest in Yourself

You are your own most valuable resource, your best hope for earning and growing your assets. Improve your ability to do that by investing in training, additional education, or by joining a professional association. It’s a good way to sharpen your skill set, pick up new knowledge, and make valuable new professional connections. The more you can improve yourself, the more valuable you’ll be to an employer or to clients.

Travel

Speaking of self-improvement, are you aware that travel broadens perspective and helps you keep problems, challenges, failures, and successes in their proper context? Think about spending a portion of your refund to go someplace new, a destination that’s always interested you.

Think of a tax refund as an opportunity, an annual chance to improve your financial situation and personal prospects. Think carefully before heading off to the Jacuzzi store or ordering a season football ticket package. By being strategic with your financial prospects, you can put yourself in a much better position to acquire those “toys” you really want and achieve financial security.

ROTH or Traditional IRA: Which Is Best?

Roth vs IRAWhat makes the most sense for you, staying with a regular individual retirement account or converting to a Roth IRA? This is not a simple question so there is no simple answer. But here are some things to ask yourself.

 

An individual retirement account is a great retirement savings tool for most individuals. Created by the federal government, IRAs are funded during your working years.  In your retirement, IRAs may help supplement your Social Security benefits.

 

Your retirement savings begin with your annual IRA contribution. If you are under age 50, the current maximum annual contribution amount is $5,500, according to the Internal Revenue Service.  For those 50 years and older, you can contribute an additional $1,000. So if you turn 50 this year, you are now eligible to contribute $6,500. The contribution amounts are adjusted for inflation each year by the federal government.

 

With a traditional IRA, you put money away and deduct it until you withdraw from the account in your retirement. You pay tax on withdrawals. Converting to a Roth IRA means you pay tax on your old account up from it, and from then on the account grows tax-free. Opening a Roth without converting is done with after-tax dollars, meaning you already paid the government.

 

 

To find out which of the two types, traditional or Roth, is best suited for you, here’s a quick way to weigh the pros and cons of each.

 

The advantages to a traditional deductible IRA:

 

Tax Deductible.  Your contribution is deductible on your federal income tax return for the year in which you contribute.

 

Tax-Deferred Growth.  Your contribution grows tax deferred until you withdraw the money. This means you do not pay any taxes while your money is growing.

 

Limitations to a traditional deductible IRA:

 

Adjusted gross income (AGI) limitations.  The amount you can deduct is limited based on your AGI and, if you participate in your employer sponsored retirement plans. Your contribution may be fully deducted on your income taxes, partially deducted or not deductible at all.

 

10% Penalty.  This is imposed to encourage IRA owners to keep their money in their retirement account until reaching age 59 ½. If you withdraw any of your money prior to then, you incur the 10% penalty on the amount you withdraw. There are some exceptions to the rule: educational expenses, first-time home purchase and certain medical expenses.

 

Advantages to a Roth IRA:

 

Avoid taxes in the future. Roth IRAs grow tax-free. Therefore, no taxes are due when you withdraw your money.

No Required Minimum Distributions (RMD).  Roth IRAs do not require RMDs after age 70 ½, so your money can continue to grow with the potential for larger dollar amounts to leave to heirs.

 

Limitations to a Roth IRA:

 

AGI limitations.  For high wage earners (2017 limits – single filing over $133,000 and married filing jointly over $194,000), Roth contributions are not allowed.

 

Disqualified distributions. The earnings in your Roth must remain in the account for five years (known as the five-year clock) and until you reach 59 ½ years. A 10% penalty is applied to earning distributions that do not meet these requirements.

 

Always consult a financial advisor or IRS publication 590 before you make your final IRA decision. Making the correct IRA choice now can benefit you down the road in your retirement.

Kimberly J. Howard,CFP

KJH Financial Services