Don’t Blow Your Next Refund or Windfall

Douglas B. Jarman, CFP®

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 realistic scenarios for most of us.  Even a modest infusion of money, such as this year’s tax refund, can yield lasting value if applied to a pressing financial need or future financial 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.  Here are some smart ideas:

Building an adequate emergency fund.  As the first step toward financial security, experts often recommend setting aside the equivalent of three to six months' living 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. 

Paying down debt.  Eliminating 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.  Also, reducing high interest debt usually makes sense 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.

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?  For example, should you increase the amount you contribute to your employer-sponsored retirement plan or a 529 college savings plan for children or grandchildren? 

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.  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, replacing your income in the event of death. Life insurance may be less important or unnecessary if you don't have dependents to protect.  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. The insurance decisions you make should be based on your family, age and economic situation.

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, 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.