A tax refund can be a pleasant surprise, but it means that you’ve overwithheld and “loaned” your money, interest-free, to the government for a year. Would that money have been better utilized if it was available in each paycheck, or is an IRS refund a kind of enforced savings for you? If it’s the latter, then fine. But if you’d rather take home more money each pay period, then you need to fine-tune your withholding.
The recent Tax Cuts and Jobs Act (TCJA) made widespread changes to exemptions, deductions, tax rates, and withholding. Learn how these changes may have caused a withholding mismatch and how you might adjust accordingly.
If you’ve got several credit card balances, car payments, and student loans, you should consider what’s called pyramiding your payments. That is, putting the extra cash toward the highest interest rate debt first (usually credit cards). Once the highest interest rate debts are gone, shift what you were paying on those to the next highest, and so on. Doing so will allow you to pay the least amount of interest over time.
You may want to investigate finding a single low-rate loan to pay off all those disparate debts. Credit cards can be particularly onerous with their high interest rates. Student loans also can be refinanced at lower rates, but be sure you understand what you may be giving up in return. You could lose the possibility of income-based repayment plans and student loan forgiveness.
52% of employees don’t have a sufficient emergency fund.1 There are dozens of situations when an emergency fund could come to the rescue, including loss of a job, problems with your car, medical emergency and sudden home repairs.
Your emergency fund should be enough to cover at least three—and as many as six—months’ worth of expenses. Finding a new job takes an average of five months,2 but your bills will keep coming regardless of your employment status.
Keep your emergency fund accessible, such as a checking or savings account (consider using an online account to keep it separate from your everyday checking account), but remember this money is for emergencies only.
If you can invest some of your new-found cash today and leave it alone (or better yet, add to it over time) you can potentially benefit from compound (read: exponential) growth over time. Each year that your money grows, a larger principal balance accrues. The next year, that new, larger principal would earn a proportionately larger amount of growth.
Here’s an example: A single investment of $1,000 earning 7% annually would yield the following:
Growth at 7% over time3
|Investment||Interest||1 year total||2 year total||30 year total|
The more money you can commit upfront to a compounding investment scenario, the better. So, maybe you’ve decided you want to invest. But where?
Increase your 401(k) contributions
Now that you have some extra cash to supplement your income, consider increasing your contributions to your employer’s savings plan. You’ll increase what you have available at retirement, and might even save on taxes and/or get more matching contributions (free money!) from your employer.
Fund your 529s
If you have young children, funding a 529 plan or Coverdell Education Savings account may be one of the smarter investment choices because of the potential for exponential growth over time. Investing early gives those dollars the best possible chance to grow, and the earnings are federally tax free if used for qualified education expenses.
Increase your IRA contributions
It’s not too early to start thinking about 2019 IRA contributions. This year, the contribution amount is $6,000 +$1,000 catch-up if age 50 or older by the end of 2019. Redirecting your excess cash into your IRA will allow you to bulk up your tax-advantaged savings.
Don’t forget your spouse
Spouses can also contribute to an IRA, even if they have no earned income. Spousal IRA rules state that one spouse with little or no earned income can still make an IRA contribution if the other spouse has enough earned income to cover the contribution, provided that a Married Filing Joint return is filed. This essentially doubles the amount you can contribute to IRAs in a given year. Maxing out 2019 for both you and a spouse allows you get $12,000 into IRAs right away (+$1,000 for each applicable catch-up contribution).
Consider a Roth IRA
Roth IRAs combine tax benefits with flexibility. Contributions to a Roth IRA are made on an after-tax basis (as opposed to possible tax-deductible contributions to a traditional IRA). However, earnings in a Roth IRA grow tax free as long as they are a part of a qualified distribution. This generally applies if your Roth IRA was open for at least 5 years and you are at least age 59½.
With Roth IRAs, non-qualified distributions are not prorated between your after-tax contribution and your earnings in the Roth IRA. If you contribute $5,000 (known as your basis) and the account grows to be $6,000, you can access your $5,000 basis at any time and leave the $1,000 in earnings in the Roth IRA. The $5,000 basis comes out tax-free and avoids any 10% additional tax, making the Roth IRA the ultimate hybrid account. It can be used as a great tax-advantaged retirement account but can also be used for needs in the nearer term.
1Ayco sample outcomes report, 2018. Includes all assessment, coaching and login data across Ayco's book of business through 9/13/2018.
2The Art of the Job Hunt, October 16, 2018, Randstad USA, https://www.randstadusa.com/jobs/career-resources/career-advice/the-art-of-the-job-hunt/631/.
3For illustration only, based on assumptions shown. Numbers have been rounded. Analysis assumes no further contributions from initial investment, return compounded annually, and does not reflect the impact of taxes. If any assumptions prove not to be true, results may vary substantially.
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Updated for tax year 2020
Updated for tax year 2019