According to the IRS 2010 Data Book, more than 3.5 million federal income tax refunds were issued last year. Georgia’s individual taxpayers received more than $11 million in refunds, placing our state as the ninth highest in refunds in the United States. Based on those statistics, there is a good chance you were one of the many individuals that received a refund from Uncle Sam.
So, what should you do with your tax refund? Let’s assume you want your money to work for you, rather than blowing it on a flat-screen television. We are going to assume that your tax refund check is for $1,000 for the following scenarios:
Scenario 1
You have just bought a home and are in the first year of a 30-year mortgage. You owe $250,000 and have a fixed interest rate of 5%. If you apply the $1,000 to one of your regular monthly mortgage payments and then continue with the regular payments throughout the rest of the loan, how much would you save? You would pay your loan off five months early. This would save you just less than $5,700 about 29 years from now—that is without factoring in inflation! If you reduced your payments slightly to pay the loan off in the same 30-year period, you would pay around $5.50 a month less for the rest of the loan. Not a ton of extra money to throw around.
Scenario 2
You have the same mortgage as in the first scenario, but you are in your fifth year paying off your home. In this instance, you would pay off your loan four months early for a savings of a little more than $4,900 in 24 years. If you reduced the payments to pay off the loan in the original 30 years, they would drop by $5.78. The difference from the first scenario is only because more of the principal has been paid off. Again, the monthly savings are not very much.
Scenario 3
Let’s consider what you would have in just a savings account at the end of your mortgage. If you are earning 1% on your savings account, you would have $1,292.48 in 25 years, or $1,341.84 in 30 years. The return is not much better with a 2% return either.
Scenario 4
With the same $1,000 refund, you decide that you are going to invest the cash for your retirement. Using the historical average return of the S&P 500, 10.8% (not adjusted for inflation), we can see what $1,000 should be when your mortgage is paid in full. In the first scenario, you would have $23,636.42 in a retirement account at the end of 30 years. For the second scenario with 25 years left on your mortgage, you would have $15,793.53. Additionally, if the original $1,000 was invested in a Roth IRA, the gains would be tax free when you reached 59½.
The Strategy
The purpose of the first two scenarios is to demonstrate how paying down a mortgage early results in a small impact to your overall debt. To maximize savings and growth potential of investments, we suggest following this strategy: Organize debts by interest rate and pay off the highest rate debts first. Your debt-to-credit ratio is a heavily-weighted factor of your credit report—meaning the more debt you carry on credit cards, the more it will impact your credit score. Plus with so many credit cards charging 18% or more in interest, paying down unsecured debt will save you the most in the long run.
We also suggest if you do not have an emergency fund, to set one up. Your emergency fund should have liquid assets that can be used to handle emergencies, should they arise. Deposit your $1,000 in a savings account, and DO NOT USE IT unless you have a financial emergency. You could opt to put the $1,000 in a Roth IRA because you could withdraw the principal without penalty; however, we would not suggest a stock fund as an investment inside the Roth.
If the only debt you have is home mortgage debt and you know you are not likely to stay in a home for 30 years, do not pay it down early. We feel you should invest the money instead. The S&P 500 historically returns 10.8%. If you were to take your $1,000 and invest it in an S&P index fund, you could have nearly $23,600 by the time you finish paying off your mortgage. You could make more than $14,000 over paying down mortgage debt early. You also do not have to worry about losing those savings if you move, because if you sell your house, the savings are lost. If that $1,000 is invested in a Roth IRA, the gains will be tax free, provided you withdraw funds after the age of 59½.
On a final note, if you had a big refund, this means you are having too much tax withheld. While many taxpayers view this as a forced savings, they do not consider that this money has no interest paid on it. You are essentially providing the government an interest-free loan. We suggest working with a C.P.A. or Tax Consultant to adjust your withholdings so you will have more money during each pay period. Regular deposits into a savings account, or using the extra money each month to pay down debt, should generate a far more positive change in your financial status. If you would like to speak one of our expert about your withholding, call us at 770-429-9166 or e-mail at experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
