Despite all of the warnings that you may have received throughout the years about giving too much to the government from your paycheck, numerous people will be receiving a tax refund this year. If you are average, that return is estimated to be in the $3,000 range. While that might seem like a windfall giving many taxpayers the opportunity to pay down a few outstanding debts, a sizable tax return can actually be working against you. Unless of course you invest it.
While I might offer some gentle chiding as to the wisdom of allowing the IRS to take more than they were entitled to receive, and adjusting your tax withdrawal to eliminate any overpayments, many of you will get a return. But what to do with it is just as troublesome.
Let?s consider the debt you think should be paid for with this return. Many taxpayers have seen a shift in what they consider normal income. You may be working a job with lower pay than in previous tax years that slipped you into a lower tax bracket. If this is the case, the return you might get can help even the family?s balance sheet. You may have been forced to use debt in a way you may not have done before. If this is the case, paying down your debt with this ?found? money is a smart move. Adjusting how much is withdrawn from your paycheck is the next best move.
But what if your personal finances were well-managed? What then? Popular wisdom suggests that you take that money and invest it for your future. But you have heard from numerous sources that lump sum investing is not a very prudent move. If the alternative is not investing at all, fearing that once you do the money will be at the mercy of the markets, what then?
There are basically two types of investing other than lump sum: dollar cost averaging and what is known as systematic investing. These two types of investing strategies are often confused with each other. Dollar cost averaging is not what you do with your 401(k) every week. Instead, this method gives you the opportunity to divide that lump sum into equal parts that invest over a period of time, usually weeks or even months. It is more of psychological crutch that allows you to confidently invest set amounts over that period without the fear of dropping the whole amount into the markets only to find that this is the day or week the markets decide to correct or even drop.
Systematic investing however is what you do in your 401(k) when you designate a set amount or percentage to be withdrawn form your paycheck. This sort of ?blind? strategy is what makes these accounts so attractive (even if they have numerous flaws from too little choice, too much choice, too costly or even no matching contribution). It is this set-it-and-forget-it methodology, contributing to your account without your emotional input that keeps you invested in good times and bad. This doesn?t mean you shouldn?t check those accounts. All it allows is for you to keep a portion of your paycheck involved in your future.
But we all know that we can?t take the lump sum and invest it in your 401(k). To invest it for your future, you will need to open another outside account. This is where a Roth IRA become beneficial. The lump sum is an after taxes chunk of money that doesn?t need to go into a tax deferred account. Roth IRAs are that kind of account. The money you deposit will always be yours and only the interest (growth) will be taxable up to a certain age. Once you hit 59 1/2, the money earned is tax free to withdraw.
Opening a Roth IRA with your tax refund may give you an opportunity that the average wage earner may not normally be advised to do. Deferring taxes as you do in your 401(k) lowers your overall taxes and this is a huge plus for most wage earners. In a Roth IRA, there is no benefit of lowered taxes which is why, if you are not fully invested n some sort of tax deferred account, you are usually told to keep your distance until they are fully funded.
So you have three things to consider. One: use your tax return to your financial advantage. If it means paying down debt then don?t hesitate in doing so ? the cost of waiting is too high. But you should also find a way to harness the spending that created the debt in the first place. Two: You could use the refund to replenish your depleted emergency accounts. Or three: open a Roth IRA, buy into the least expensive funds available (be it indexed mutual funds or ETFs) and let it grow. You can invest in this fund systematically or in a lump sum. But to do nothing (other than spend it) is a crime against your future. It isn?t a windfall so much as it is an opportunity.
Related posts:
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- Retirement Planning: Selling Boomers
- Retirement Planning: Using Leverage to Fund Retirement Accounts
Source: http://target2025.com/retirement-planning-your-tax-return-and-what-to-do-with-a-lump-sum/
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