Mellody is President of Ariel Investments, a Chicago-based money management firm that serves individual investors and retirement plans through its no-load mutual funds and separate accounts. Additionally, she is a regular financial contributor and analyst for CBS News and CBS.com.
Skip: This morning we are talking about tax refunds.
Melody: That’s right. Every year around this time, millions of Americans receive tax refunds, but very few Americans will take advantage of this windfall to advance their financial wellbeing, Skip. This morning, I am here to be the little angel on your shoulder, giving you some options for your tax refunds that will keep you in safer financial straits and ultimately put you on a path for a more secure future, even if it does mean forgoing a new TV or pair of shoes.
What’s your first suggestion for our tax refund?
I probably sound like a broken record, but if you do not have one already, my first suggestion is absolutely to create an emergency fund. But there is a reason I raise this again and again! One report from Pew Charitable Trusts last year which found that 55 percent of households didn’t have enough liquid savings to replace a month’s worth of lost income, and another found that of the 56 percent of people who said they’d worried about their finances in the previous year, 71 percent were concerned about having enough money to cover everyday expenses. A third study (not from Pew) asked individuals whether they could “come up with” $2,000 within 30 days for an unanticipated expense. Just over one-quarter of Americans could not, and another 19 percent only could if they pawned belongings or took out payday loans.
Unexpected expenses are almost certain to pop up in our lives at some point, and they can be devastating if we are not prepared. If you do not have one already, make it a point to use your refund to start an emergency fund! Your goal should be 3 months of living expenses, but start off by building your fund up to cover one month.
If we have an emergency fund, what is the second thing we should do with our tax refund to improve our finances
The next thing you want to do is use your refund to deal with any problematic debt that you have. First things first: If you are behind on payments for secured debt, meaning an asset is tied to it such as your home or your car, you should absolutely prioritize that debt. If you are able to cover all of those costs, then you want to turn your attention to unsecured debt. If you’re deciding between paying down credit cards, student loans and personal loans, the easiest way to choose is to look at the interest rates for each category. Then use your tax refund to use by paying down your highest-interest debt (most likely credit cards) so this debt doesn’t grow
However, there is one exception that comes in the next option for your refund.
What is the next option?
Your retirement savings. One of the best thing you can do with your tax refund is drop it into your 401k or retirement account, because the power of compound interest. If you deposit $1,000 and get a 4.5% return over 25 years, you will triple your money. That is a great use of a refund to build your retirement. But the exception that I was just talking about builds on this. If you are able to cover your credit card bills, and your employer matches your retirement account contributions but you are not taking full advantage of this, putting your refund to work in your 401k could receive a 100 percent ROI instantly when you get your employer match. If we consider the same $1,000 refund at the same return, but it gets matched, over the same 25 year period it will grow to over $6,000. That is a huge opportunity if you forgo the instant gratification of spending your return now and focus on your long term goals.
All of these options are choices to prioritize our future over our present.
That’s right, Skip. Preparing and saving for our financial future has really fallen by the wayside in the US. The personal savings rate has fallen from a peak of 13.3 percent in 1971 to 5.1 percent last year. Nearly 30 percent of American adults don’t save any of their income for retirement. Low savings combined with increasing consumer debt is a recipe for financial disaster. So this year, I urge all of our listeners to use your refund to think for the long term!
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Money Mondays: What To Do With Your Tax Refund was originally published on blackamericaweb.com
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