(This is the second in a four-part series about the wise use of your Federal Income Tax Refund.With the exception of the first post, the advice in this series applies to any windfall – lottery winnings, gifts, even yard sale proceeds.)
In the first post in this series, we discussed the real meaning of a Tax Refund. In this post, I will explain how to get a guaranteed return on the investment of your refund.
Like I said, it is a Tax Refund. That it is the government returning money to you that it took from you in the first place. Let’s say it a different way: The government took more of your money than it was entitled to, so it has to give some of it back. In summary, a tax refund is your money because it already was your money. It is not a gift. It is more like a forced savings account.
The shortened version: A tax refund is the annual payout of your savings. (Kind of like the Christmas/Vacation Club accounts we talked about in the earlier post.)
Now that you’ve saved your money, what are you saving for?
You don’t know? Really?
Well, I’m not exactly surprised; it’s hard to know what your saving for when you don’t know how much you’ve been saving. Most of us don’t know how much we will be getting back each year because we’re not diligent about monitoring our withholding percentages and/or the tax code is too complex for us to comprehend. As for me, I’m guilty of both – especially the second.
Again, the complexity of the tax code and the distribution of refunds in excess of contributions leads to a political discussion that I’m not hosting here. Please don’t waste time in the comments on politics or the like.
A Guaranteed Return
That said, if you have not already, you are probably about to receive a check (or direct deposit) from the government for the forced savings account held at the IRS. Needless to say, the federal government is not paying any interest on the accounts that it has held for the last year. That does not mean that you must settle for this money to bring you no returns.
Many people I talk to are discouraged by the interest rates on deposits at their local banks. So discouraged, that many think the only alternative to a 0.01%APR savings account is to just spend the money on something they want – even if that is dinner or a big screen TV. Where’s the return there? (Hint: There isn’t one.)
So, what’s the best way to invest your tax refund and get a decent return?
It is much easier than you may think to get a guaranteed return on your investment – and you don’t need to pay a financial advisor to get that return. Do you know of any stocks or bonds that guarantee you a return of 5%, 8%, 15% or even 25%?
Don’t think too hard. I’ll answer for you – you don’t know of any such investments.
Mind you, I’m not talking about the one your cousin Willie’s neighbor Frankie’s uncle Louie heard about from a guy at a poker night somewhere. I’m talking about a legitimate investment that pays a legitimate, guaranteed rate of return.
Or, maybe you have heard about it… If you think of it differently.
According to BankRate.com, the average credit card interest rate (depending on the type of card) at the time of this writing is between 11.61% and 16.60%.
Follow me, here. I know I just went from talking about investments to talking about credit cards and that might seem like a bit of a jump. Just to be clear, credit cards are the opposite of investments – the former can cost you money while the latter can make you money. However, we are talking more about returns than investments.
Let’s think of it this way: If you carry $1,000 balance on a credit card that has a 15% interest rate, you’re paying $150 per year in interest. If you use your $1,000 tax return to pay off that balance, you are saving $150, effectively earning you a 15% return on your $1,000 – a return that is nearly guaranteed.
Notice I said “nearly” guaranteed. Yes, you paid off a $1,000 credit card with a 15% interest rate – you are guaranteed to make a 15% return on that $1,000. However, you will lose your return if you turn around and use that card to create a new balance. Paying off a credit card only to use that credit card again is no different than just blowing your tax refund. The only difference is that you are more likely to experience the discouragement that comes with realizing you’ve undone something that you were proud of doing. That’s a negative return.
This same principal works with any type of debt, whether you pay off the debt completely or not. Say you’ve got a car loan with a $15,000 balance at 7% and you get that same $1,000 tax return.
On the car loan, you’re paying 7%, or $70 per $1,000 owed, in interest – each year. Your monthly car payment is the sum of the interest that has accrued on the loan in the last month plus a calculated amount of principal. The principal portion is the part that pays down the loan balance.
If you use your $1,000 tax refund to pay down the balance of your car note from $15,000 to $14,000, you’re saving $70 per year, every year – that’s $350 over five years. Not to mention, you will pay your car off sooner.
It is exactly the same principle with your home mortgage, only you’re likely paying a lower interest rate over a longer period of time. Let’s say you’re paying 4% with 25 years left on your mortgage. Reducing the balance by $1,000 this year will save you $40 every year. Over the course of 24 years, that’s a savings of $960 – you will have nearly doubled your money. And, that’s just if you use your tax refund to pay down your mortgage this one year.
If you consistently use your tax refunds for this purpose, just imagine
- how much money you’ll save in interest and
- how it will feel to actually own your stuff free and clear of any liens.
Just wait, though, don’t start writing checks just yet – not for TVs and not for debt reduction. Just put your tax refund in a safe place until you read the next post: What’s the Value of An Umbrella In A Downpour? (coming soon)
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