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Deductions and Credits
Ideas for Putting Tax Refunds and Other Windfalls to Work
By Jay Butler
Senior Associate, Bay Financial Advisors, Inc.
Achieving a six-figure bonus at work or winning the top prize in a professional golf
tournament certainly are two types of windfalls anyone would love to get their hands on. But
receiving a large tax refund or coming into an inheritance may be more plausible scenarios.
Even a modest infusion of money, such as the $2,171 average refund the IRS issued in
2005, can yield lasting value if applied to a pressing financial need or future goal instead of
the pleasure of a shopping spree or vacation.
You can put a tax refund or other newfound wealth to work in a number of ways. Some
ideas include:
Building an adequate emergency fund
As the first step toward financial security, experts
often recommend setting aside the equivalent of three to six months’ expenses that could be
drawn on in case of a sudden need. To make sure that money will be available on short
notice, emergency reserves should be held in a relatively liquid investment, such as an
interest-bearing savings account or a money market fund. Also make sure that your
emergency fund keeps up with increases in your expenses and the impact of inflation.
Paying down debt
Judging from the nation’s slide into a negative rate of savings during
2005, reducing credit card balances and other consumer debt should be a priority for many
households whose burden of debt restricts their ability to save and invest for the future.
Reducing high interest borrowings usually makes sense as well for those with smaller debt
loads, in part because interest payments on credit cards, auto loans and unsecured
consumer loans are not tax deductible.
But even on loans such as home mortgages where interest payments are tax deductible and
interest rates are relatively low, paying down debt can be a sensible move. Using a windfall
to trim such a loan can increase the amount of money available for saving or lower cash flow
needs in retirement, for example.
Investing for the future
If you are prepared for a financial surprise and have debt under
control, you can turn to more forward-looking uses of newfound wealth. Take a close look at
your goals to help you decide how to invest the extra money. Are you on track to reach
some goals but behind on others? Should you increase the amount you contribute to your
employer-sponsored retirement plan or 529 college savings plan, for example?
Protecting against risks
Adding to your insurance protection is another financial planning
improvement to consider in the event a windfall comes your way. There are many forms of
insurance that protect against the cost of accidents, illness, disability and death. However,
there are no one-size-fits-all policies. Instead, the insurance decisions you make should be
based on your family, age and economic situation. For example, there are two basic types of
life insurance: term policies, which pay a death benefit for a specified period of time, and
whole or universal policies, which have no term limit and accumulate value over time but
generally cost more than term policies.
In addition to maintaining adequate coverage for your home, auto and the like, life insurance
is a virtual necessity if you have a spouse and children in order to cover their living and other
expenses in the event of death. Life insurance may be less important if you don’t have
dependents to protect. (On the other hand, disability insurance, which provides an income
stream if you are unable to work, is important for everyone.)
With the rising cost of health care, longer life spans, and uncertainty about the future of
Social Security, you may also want to consider long-term care insurance, which helps pay
for nursing home or at home health care if the need should arise.
These are but some of the possible uses for a windfall. In the short run, however, keep in
mind that you don’t need to be expecting a refund to make use of the planning opportunities
that tax season opens up. So, even if you’re not anticipating a windfall from Uncle Sam or
another tax collector, you may want to review your overall financial situation and planning
priorities while many of the details are fresh in your mind from completing your tax chores.
As a financial advisor, I will evaluate and help you to implement the most appropriate
financial solutions to give you the highest probability of achieving your goals for the reasons
that are important to you.
Advisor is a registered representative with and offers securities through Linsco/Private Ledger Member NASD/SIPC
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