Published April 19, 2013
It’s Christmas in April. That’s how it feels for many of us as we eagerly await our refund from Uncle Sam, but it’s important to take stock of your financial situation before making any decisions on how to allocate the funds.
Everyone’s priorities are going to be different. Families enduring some kind of hardship, such as a job loss or an expensive medical emergency, will almost certainly spend their tax return on their most pressing immediate needs. But if your day-to-day financial situation is reasonably stable, you need to set priorities to make the best use of your refund.
There are three broad spending categories into which our financial decisions fall: necessary, discretionary and savings. Within these categories we have many items competing for a share of our wallets, like the electric bill, basketball box seats and of course, your retirement portfolio.
Your first decision should be which of the categories will benefit from the refund. Are you going to put it towards staples like rent, gas or groceries? Assuming your day-to-day financial situation is stable, these items should already be at the top of your monthly budgets (where they hopefully comprise no more than 50% of your total monthly take-home) so that leaves discretionary spending and savings. A couple thousand dollars in hand can make it awfully tempting to indulge in a big-ticket item you’ve been eyeing for a while. Before you give into the temptation, though, think about how these funds could be used to support your longer-term financial goals.
Compound Earnings: Earlier is Better
Are you one of those people who always puts off saving, assuming that you’ll get around to it later? There are economic consequences of this procrastination. Every day you wait, you deprive yourself of the benefits of an incredibly powerful agent working on your behalf: compound earnings.
Here’s an example: If you invest $10,000 and earn an average annual return of 8%, your investment will grow to $21, 589 in 10 years. Your gross earnings (before fees and expenses) are $11,589. Not bad!
But what if you keep that money invested for 20 years? Your initial $10,000 will grow to $46, 610 – more than 4.6 times your initial investment. The more time you give your assets to grow, the faster the rate of acceleration. That’s the power of compound earnings.
You can see from the above example what can happen if you put that tax refund into your retirement portfolio and watch compound earnings work its magic, but you may have other goals in addition to retirement. Perhaps you’re saving to send your children to college, buy a home, or to start up a business. Whatever the goal, you’ll be that much closer if you start putting your money to work now. Think about that when the little yellow envelope from the Treasury Department arrives in the mail or gets deposited into your bank account in the next few weeks.
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