What should you do with your refund?

By Al Giovetti, CPA, President, Maryland Society of Accountants, Catonsville, Md.

The good news for small-business owners is that, with sound tax planning, they may be eligible for refunds on their personal taxes. The bad news is that many are squandering their refunds irresponsibly.

If you receive a refund, ultimately, it's your decision what you do with it. As tax professionals, we see the financial impact of making bad decisions. Most people blow their refund on a vacation or unneeded items, such as the down payment on a new car, when the old car is doing just fine.

Why consider alternatives to spending?

Unfortunately, the responsible things to do with your refund are not the fun things that usually rise to the top of your list. Most people don't engage in serious consideration of alternatives. The majority of Americans just like spending money and would do anything to avoid saving it. Savings has become a dirty word.

Gambling is tantamount to throwing your money away. Nevertheless, a substantial percentage of Americans spend money to support the lottery. Many more Americans choose Atlantic City and Las Vegas casinos as their vacation destinations, fully realizing that the odds are on the house, but ignoring the opportunity to apply their refund to reduce their accumulated debt.

A new car may not be the best idea when the old car is still running well. A few hundred or even a few thousand dollars for repairs are a much cheaper alternative than paying $399 a month for the next 60 months. We know what we really need to do with that refund, but that new-car smell gets us every time.

Buying a new car to save money on gasoline may or may not be worthwhile. It depends upon how much driving you really need to do, multiplied by the savings in gasoline, divided by miles per gallon, compared to the incremental cost of buying the car over keeping the old car. Your accountant can do the math, but you may not like the answer you get.

Pay down the debt

Most American taxpayers are in debt up to their ears, and they really don't need or cannot afford to refinance their house with a new mortgage to consolidate credit cards. Why not take the refund as a first step toward paying off those cards? Get on a budget and resolve to pay down the balance a little each month with payments toward the principal of the debt.

If your credit-card debt is out of control, one of the worst decisions you can make is to get a bill-consolidation home mortgage loan. When you put your credit card debt on your mortgage, you put your house at risk, and it does nothing to stop the self-destructive behavior that got you in this mess in the first place. The first rule of managing debt is never to convert unsecured debt to secured debt. Furthermore, never convert short-term debt to long- term debt. Credit-card debt is short-term unsecured debt, while mortgage debt is long-term secured debt.

Refinancing your mortgage as a bill consolidation loan is not cheap. Average settlement costs equal as much as $5,000. Some loans have points or lender's fees, which represent upfront interest that could run the settlement costs up to $10,000 on a small home loan. That $5,000 could be used to pay off some of your credit-card debt.

Contrary to popular belief, not all mortgage interest is deductible. The amount of the increase on the principal of your mortgage resulting from bill consolidation is home-equity debt. Interest on home-equity debt that exceeds $100,000 of debt principal is not deductible. Multiple refinancing, cashing out your mortgage, and bill-consolidation refinanced mortgages easily can exceed this $100,000 limit in some parts of the country.

Credit cards are the worst place to carry debt, because they have the highest interest rates possible. Credit cards are best used to pay bills when you pay off the entire balance on the account every month. The interest rate on carrying credit-card balances is crippling, and if you make the minimum payment, your debt will double in just a few short years.

Some people even trade one card for another card, using the zero-percent interest on the new card until it runs out, then getting a new card with zero percent interest. Robbing Peter to pay Paul won't get you out of debt. You need to get serious.

Go to a reputable credit-counseling agent, and cut up all but one credit card. Only use that card for payment convenience, and don't use it at all if you cannot pay it off every month. Credit-counseling services consolidate your credit-card debt, lower the amount of your monthly payments, cut the balance of your principal and reduce the interest on the remaining debt as far down as zero percent.

Sometimes you can approach the credit-card company directly with your tale of woe and ask to be considered a hardship case. We have seen the credit-card companies lowering interest to zero percent and cutting the balances on the cards on their own when faced with hardship. They also will cancel your credit cards, which is a good thing.

If you have credit card debt, use your refund to start getting out of debt today. If you don't do this, somewhere down the road you may be forced into bankruptcy. You could even lose your house, which is your most important investment. You need to turn around bad credit habits decisively and firmly or you will never get out of debt.

Invest in the future

Once you are out of debt, you can begin to think about investing in your future. If you have no debt, you can invest. It is ridiculous to borrow money at high rates to invest at lower rates. This will make you broke faster than mounting credit-card debt. It is not smart to borrow money to invest, and if you invest when you have any consumer debt, that is just what you are doing.

Real estate investments

One of the most profitable investments you can make is in real estate, specifically your own home. Real-estate values continue to rise, and instead of paying rent to a landlord and buying him real estate, make a mortgage payment and buy your own house. As you get older, you will pay off the loan and have a tidy, tax-sheltered investment for your retirement years.

Retirement plans

One of the most valuable things you could do with your refund is investing in a retirement plan, such as a traditional individual retirement account (IRA) or Roth individual retirement account (IRA). More than ever today, you need to start as early as possible preparing for your retirement years. People are living longer and the resulting medical costs are amazingly expensive.

Most retirement plans that people have though their employers are woefully inadequate. Many recent retirees are finding it impossible to live on their retirement, investments and Social Security payments. Many retirement plans pay between $20,000 and $30,000 per year for employees who made $120,000 to $200,000 during their lifetime.

The age of generous retirement plans is over, and inflation is eating up these plans at a very rapid rate. Inflation is much higher than the cost-of-living increases you see in the newspapers. Many recent retirees find themselves going back to work on vastly reduced pay, just so that they can pay the bills for food, lodging, medical care, transportation, energy and other necessities of life.

You can put your money in 401(k) or 403(b) (deferred compensation) savings plans or employee stock option plans (ESOP) at work. Use your refund to finance these withdrawals from your paycheck by keeping the money in the bank to supplement the everyday costs of running a home. If you are self-employed, Keoghs or SEP IRAs are good investments. When you have your taxes prepared, your tax professional can tell you how much to invest and where to invest it.

Education funds

Another good place to spend your refund is on education for yourself or your children. The more you know, the more marketable you are. Children's education money should be placed in a real trust drawn up by an attorney. Another option is Section 529 plans. Every state has an approved 529 plan. The money is put aside in today's dollars, and the school usually will accept the money today against the tuition when the child attends college. The money in the plan can be switched from child to child and in many cases from school to school within families, as long as the funds are used for education.

Money given to children under the UGMA (Uniform Gift to Minors Account) and UTMA (Uniform Trust for Minors Account) is turned over to the child when he or she reaches 18 and 21 years of age respectively. This is the wrong time for a child to get the funds. At age 18 or 21, the child is more likely to blow the money on a car or motorcycle.

Stocks

One place to put money for long-term growth is in stocks. You can get started purchasing stocks for a few thousand dollars. Don't buy the stock unless you intend to keep it for a long time. The stock market goes up and down continuously, and if you cannot weather the volatility of stock values, you will likely sell when the stock is devalued and lose your shirt.

The best advice overall is to try to resist the urge to blow your entire refund on luxury items, trips or unnecessary expenditures that you "just must have." Your refund can be a first step toward sensible financial planning for the future.

About the author

Al Giovetti, CPA
President, Maryland Society of Accountants, Catonsville, Md.
Al Giovetti is a Certified Public Accountant and partner at the firm Giovetti and Giovetti. Giovetti holds a bachelors degree in biology from LaSalle College, as well as a doctorate degree medical microbiology from George Washington University and is president of the Maryland Society of Accountants. Over the course of his career he has published a number of articles on the topics of accounting and computers and is a lecturer for professional organizations and colleges. Giovetti is the host of “The Computer Show”, a weekly cable television program dedicated completely to computers. He resides in Catonsville, Maryland, is married to his wife Christine and has four children.

Note: The following information is provided to you by third parties for informational purposes only and shall not constitute tax or legal advice. Microsoft Corp. has not checked or verified any of the information provided and makes no representations or warranties as to its accuracy. Each individual’s tax situation is unique, and you should check with your accountant or other tax professional for particular advice on your situation.