It’s easy to take a tax refund and spend it on a new television or a vacation. It’s much harder to take that entire amount and pay off some existing debt (credit cards, student loans, etc.). It is just not as much fun doing the latter. There are other times that we receive money that we are not expecting (or budgeting) for such as inheritances, bonuses, and other miscellaneous refunds or extra income. Savings windfalls instead of spending them takes planning and discipline and many people don’t even realize they are missing out on a key opportunity to change their financial well being.
First of all, I hope everyone tries to limit their tax refunds to under $1,000. Letting the government borrow your money all year for free is not a good idea. If you were to adjust your paychecks, it might be easier to increase those 401k/403b contributions each month! Large refunds are more loans than found money, but if it occurs you should treat it the same.
I will say it has been difficult to master the tax withholding being married as there are many more variables to consider, so I have not actually taken my own advice for fear of over-correcting. I have tried to tweak it, but will definitely end up with a large refund due to the 30% federal tax break on my solar purchase. I wouldn’t’ be surprised if it’s a couple thousand higher than that credit. That means I have been missing out on something like $200 a month that could have been used already instead of waiting until March 2015 to be utilized.
I did recently increased my payroll withholding because of a last minute effort to max out my 403b for the year (sadly I waited too long to change it, but its fixed for 2015). I also got a bonus for not using much sick time that I consider found money, which is a chance to save extra money. I don’t count on the bonus as I might get sick or have to take time off for the kids being sick, so it is a great day when I get that extra paycheck. The net result was about an extra $500 towards my 403b, $500 towards dwindling student loan balances, and knocking out a $700 medical bill that just came in recently (great timing). The remainder was put into a Traditional IRA that should hit the $5,500 max for 2014 (started kind of late, but this bonus and another in December should help top it off for 2014. The good news is none of the bonus was spent frivolously this time around!
Also, if you are planning on a large inheritance to be your retirement plan, you may want to think of a back-up plan. I see too many examples of frivolous spending from getting large sums of money, that it scares me. Hasn’t everyone heard that most lottery winners end up working again because they run out of money? Managing a large sum of expected cash should involve a cooling off period before spending or investing any of it. I would probably max out all possible tax advantaged retirement accounts immediately, then take a step back and see what else it could be used for down the line. Either way, I would be focused on saving windfalls, not spending them.
I used to take my tax refund and spend it on wants, not needs (like a tv or trip). Now I consider that refund to be either debt payoff funds or retirement contributions. Nothing else. Someone that values financial freedom and wants to retire early needs to have the financial discipline to ignore the large balance in the checking account and just pass it right through to retirement accounts or a debt payment.
Advice for Saving Windfalls
I think having a plan on which debt to apply the tax refund or windfall to is a good idea. If you are paying off consumer debt, the highest interest rate debt would be the mathematical choice. For example, if my refund were $10,000 I would immediately put about $9,500 of it towards the solar loan (at 0% on my credit card in anticipation of the federal tax credit in 2015). I would then use the remaining $500 to shore up our cash balances and maybe use a small amount for a nice dinner or taking the family to the movies. If I had credit card debt carrying an interest rate, I would put ALL funds towards that first.
Think about this example another way: tax refund of $10,000. If you were to immediately max out a Roth or Traditional IRA at $5,500, you would be ahead of the game and free up cash flow the rest of the calendar year that would have gone towards that limit. You could also go a long ways towards paying off a small credit card balance, medical bills, or student loans. Another option would be to keep it in your checking or savings account for an expected large purchase like an air conditioner, house or car repair, or even a trip. I don’t think there is a wrong choice as long as the funds are directed towards retirement savings or debt payments.
The consumer mindset is more income means more money to spend. The early retirement mindset is different. When you get extra dollars, you have to put them to work, not buy more things. It is still a struggle for me sometimes, but my goal of financial independence pushes me to use the majority of it to increase my net worth. Saving windfalls to increase retirement savings is definitely a great way to supercharge your investment balances!
Has anyone had a difficult decision with a large tax refund or other large sum of money coming in unexpectedly?