The Internal Revenue Service expects more than 153 million tax returns to be filled this year with nearly 111 million taxpayers receiving a refund. That’s right – over 70 percent of Americans may have overpaid the IRS in 2016 with an expected average refund of over $3,200. While tax refunds may feel like “found money”, it's important to remember that it simply represents extra money that you withheld from your paycheck that may have been unnecessary. Rather than spending a tax return on something frivolous, why not apply these funds toward improving your finances for 2017?
Pay down high-interest debt
According to Bankrate.com, the average interest rate charged on credit cards as of 3/1/17 was 16.52 percent. With the Federal Reserve, having just increased interest rates for the 2nd time in 4 months (many analysts believe we will continue to see additional rate hikes in 2017), the interest rates charged on most forms of consumer debt is expected to increase. Paying off debt that is charging interest is the equivalent of achieving that rate of return on your money. For example, paying off a 14 percent credit card with your tax return is the equivalent of achieving a 14 percent return on those funds. Keep in mind, it is important to build sufficient cash reserves before sending your entire return to a creditor as a lack of cash generally leads to incurring debt.
Consider paying down the highest-interest debt first while continuing to make minimum payments on any lower interest debt you have. This may also help to reduce interest costs while expediting the payoff of debt in the future.
Build an emergency fund
Few Americans maintain sufficient emergency funds. Why? Generally, because previous emergencies have sapped a large portion of savings often resulting in the reliance of debt. You may be familiar with the term “pay yourself first”. Stashing away a portion of your tax return toward an emergency cash reserve is a great way to accomplish this. Maintaining at least 6 months of expenses (9 months is even better) may provide the safety net necessary to help cover unforeseen expenses or a job loss.
Take advantage of tax-deferred retirement savings
What If there was a way to utilize this year’s tax return to reduce your tax liability for next year? Well, investing your tax return in a pre-tax Traditional IRA, 401(k), 403(b), 457 plan and the like is a way to accomplish just that. For 2016 and 2017, taxpayers can save $5,500 in a traditional IRA ($6,500 if over age 50). Depending on income levels, you might also consider a combination of IRAs and employer sponsored plans like 401(k)s. (Maximum 401(k) contributions are $18,000 ($24,000 if over age 50) in tax advantaged savings).
In addition to pre-tax accounts, taxpayers in low tax brackets may want to consider a Roth IRA. While a Roth IRA does not provide an immediate tax deduction, it may provide tax-free growth when used appropriately. Consult with your financial or tax adviser to determine whether a Roth or Traditional plan makes financial sense for you.
Fund a college savings plan
With interest rates on the rise and over $1.3 trillion in student loan debt outstanding, earmarking a portion of your tax return toward your child’s future education expense may also be a great option. Consider assessing the benefits of a 529 plan as they can be one of the most tax-efficient ways to build funds for college. While, savings used for qualified education expenses from a 529 plan grow federally tax-free, investment gains not used for college may be subjected to both a 10 percent penalty taxes.
Lump sum contributions from a tax-return in combination with systematic monthly savings may help supercharge college savings for future expenses.
Adjust your withholdings
If you consistently receive excessively large tax returns, it may be time to speak to your tax professional about adjusting your withholdings. Remember, a large tax return is nothing more than an interest-free loan to the IRS that could have been applied to other goals. For example, a $5,000 return could provide nearly $400/month of additional cash flow that could be working for you all year in cash reserves, education funds or retirement accounts. While increasing cashflow may be beneficial, withholding too little can result in owing the IRS where penalties and interest could apply. Consider speaking to your financial and tax advisers to determine which approaches are best for your unique circumstances.
Kurt J. Rossi, MBA, CFP®, CRPC®, AIF® is a CERTIFIED FINANCIAL PLANNERtm Practitioner & Wealth Advisor. He can be reached for questions at 732-280-7550, kurt.rossi@Independentwm.com, www.bringyourfinancestolife.com & www.Independentwm.com. LPL Financial Member FINRA/SIPC.