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When the check from the Internal Revenue Service shows up in your mailbox (or is electronically deposited into your bank account) the urge most have is to take the money and buy a 55-inch TV or a new wardrobe, but experts say there’s a better thing to do with that tax refund – save or invest it.
Darla Colson, CPA, MST, of Gilbert Associates, Inc., CPAs and Advisors, says the majority of people don’t budget for their tax refunds or plan how to use them, so they tend to spend them on items they want rather than items they need. While that can be instantly gratifying, the money is often spent on something that is barely remembered the next year.
“By saving your refund, you can compound the effect of the refund for years to come,” Colson says. “You can build up a rainy day fund, increase savings for retirement or increase savings for college.”
One of the best ways to save – and turn some of your income into tax-free savings – is to put the money into a 401(k) or similar retirement fund. If the tax return is $1,200, then putting an extra $100 into a 401(k) each month leaves you with the same money in-hand, but that extra $100 per month is coming out of your paycheck tax-free. “Put the refund to work for you by having it help you save additional taxes in the current year,” Colson says.
People all need to save differently, depending on where they are in life, Colson adds. “Your age, marital status and phase in life will all affect the best places for you to save money,” she says. “From the time you start your first job through the day before retirement, saving money for retirement is the most important savings you can make.”
She advises saving 10-15 percent of all income for retirement. If you start that on the first day of work, you learn to live within the smaller income, and you will have much more money when it comes time to retire. The earlier you start saving, the more money you will have. Starting late means needing to make up for lost time, and that gets tough both mathematically and when it comes to living within the smaller means once you start putting more money away.
Many young parents, she adds, want to save money for their kids’ college funds, but she advises to save for that only after saving for retirement, as most parents end up paying for the college expenses out of their current earnings while the kids are at school.
In some cases, spending your tax return may be the best way to save in the long run, Colson adds – but don’t head to the local Best Buy just yet. First priority, she says, should be paying off high-rate debt such as credit cards. Paying off that debt will mean less out-of-pocket money spent on interest fees in the long run, and is often a smarter financial decision.
THE FOUR STEPS TO CASH MANAGEMENT
by Darla Colson, CPA, MST, of Gilbert Associates, Inc., CPAs and Advisors
Colson suggests spending a few minutes each week to maintain a cash management program that revolves around the four “As” – accounting, analysis, allocation and adjustment.
1. Accounting quite simply involves gathering all your relevant financial information together and keeping it close at hand for future reference. Gathering all your financial information — such as mortgage payments, credit card statements and auto loans — and listing it systematically will give you a clear picture of your overall situation.
2. Analysis boils down to reviewing the situation once you have accounted for all your income and expenses. You will almost invariably find yourself with either a shortfall or a surplus. One of the key elements in analyzing your financial situation is to look for ways to reduce your expenses. This can help to free up cash that can either be invested for the long-term or used to pay off fixed debt.
For example, if you were to reduce restaurant expenses or spending on non-essential personal items by $100 per month, you could use this extra money to prepay the principal on your mortgage. On a $130,000 30-year mortgage, this extra $100 per month could enable you to pay it off 10 years early and save you thousands of dollars in interest payments.
3. Allocation involves determining your financial commitments and priorities and distributing your income accordingly. One of the most important factors in allocation is to distinguish between your real needs and your wants. For example, you may want a new home entertainment center, but your real need may be to reduce outstanding credit card debt.
4. Adjustment involves reviewing your income and expenses periodically and making the changes that your situation demands. For example, as a new parent, you might be wise to shift some assets in order to start a college education fund for your child.
Using the four “As” is an excellent way to help you monitor your financial situation to ensure you’re on the right track to meet long-term goals.