What should I do with tax refund? – Ask The M-Network

By glblguy

ask-the-m-networkThis article is part of the Ask the M-Network series. Samantha submitted a question and asked:

Hi, we recently finished our taxes and will be getting back a 13K refund (part of it is the first time home buyer’s credit which I realize is more like an interest free loan). We want to know what the smartest thing to do with the money is in these tough economic times.

My husband and I are in our early thirties. We have a mortgage, student loan debt, and credit card debt. The credit card debt is about 8K but there is no interest accruing on that card until Nov 2009. We have paid down the card a lot by putting 4K towards the card every month for the past 3-4 months.

We have a take home pay (after taxes) of about $8500 a month. Our monthly expenses total about 4K a month.

We have not contributed any money into our Roth IRA for 2008 and want to know whether we should both contribute before the April deadline. We could use the tax refund to put about 4K each into our Roths.

Our main concern is that we do not have an emergency fund at all. My husband’s company has recently had a round of layoffs, but he was spared. We would love to contribute to our retirement, but wonder if that is the smartest move in this economy.

The bottom line is: should we contribute to our Roths with our tax refund or put it away in an emergency savings fund? I’m pretty sure that if my husband were to get laid off, the firm he works for would offer a 3-4 month severance package. Also, this may be one of the last years we can contribute to the Roth
since our income may be beyond the limit in 2009.

Any advice would be greatly appreciated.

David from My Two Dollars responds:

You should pay off the credit card debt first, and anything left over I would put into an emergency fund of at least $1000 or so. If you still have money left over, then contribute to your retirement account. At your age, I would work harder paying off debt before worrying about a small amount of retirement savings Consider that $13K a gift and get rid of the debt with it first, especially the part that the government is giving you in the form of that $8K. It’s not a loan – you do not have to pay it back, it is designed to encourage people to buy homes in this economy. Good luck!

Patrick from Cash Money Life says:

I have a different approach from David – I think it might be a good idea fund Roth IRAs. Right now you and your husband are working with a $4,500/month surplus, which is a large enough amount to get ahead over the next few months, but you won’t be able to contribute to a Roth IRA beyond next month.

Since you will likely price yourself out of the Roth IRA market next year, I would try contributing to your 2008 Roth IRAs before April 15th. The 2008 and 2009 Traditional and Roth IRA Contribution Limits are the same and top out at $5,000 for each person. So you could actually contribute $10,000 for your 2008 Roth IRAs. If that is too much, then you can consider contributing a portion of your return – you don’t have to invest all of it.

The economic crisis has slaughtered the stock markets over the last few months, but that may actually work in your favor because the lower stock prices make some equities and investments more attractive. Since you have 25+ years before your retirement, now may be a good time to invest.

The key to making this work is to use your free cash flow over the next few months to take care of some very important matters – setting up an emergency fund and paying of your credit card debt. I recommend taking your extra money every month and putting it into a high yield savings account and leaving it there until your credit card debt is due – then paying it off in full so you don’t accrue interest. In the mean time, that money can serve as an emergency fund until you pay your credit cards off. After you pay them off, you can start building you emergency fund back up. Since there is the remote possibility of a layoff, I recommend saving up at least 6 months of living expenses in your emergency fund.

Pinyo from Moolanomy shares his perspective:

If you strictly follow Dave Ramsey’s Baby Steps, you should start an emergency fund with $1,000, pay down your credit card debt with $8,000, and add the remaining $4,000 into your emergency fund. This leaves you with a good $5,000 emergency fund and no more debt.

However, that’s not what I would do if it was my decision. I agree with Patrick that it might be better to fund your Roth IRAs with the money you’re getting due to your situation and the current stock market condition. If you make the maximum Roth IRA contribution for 2008 for you and your wife, the $10,000 could translate into a lot of money in the future. This still leaves you with $3,000 to get a good jump start on your debt. If you plan it right, your credit card debt will be paid off before November 2009 and you’ll have two fully funded 2008 Roths. But note that you’ll need to file an amended tax return to let the IRS know that you fund your Roth IRAs, unless you already reported that you did.

As for the emergency fund, I wouldn’t worry about it until your debt is paid off. You could always use your credit card in an emergency. Additionally, I believe you could withdraw principal amount from Roth IRA without penalty if you really need the money — however, I don’t recommend this and I would check with a tax adviser just to be sure.

Obviously, the Dave Ramsey’s method is a lot safer than the alternative discussed above. You’ll have to decide which option is best for you.

On a different note, you’re definitely withholding too much money ($5,000 refund without the home buyer tax credit). This is essentially giving the government an interest free loan. Personally, I recommend that you update your W4 so that you keep more money with each paycheck. You could use the extra money to pay down your credit card debt even faster.

I hope this helps.

Here’s my take:

If I were you, I would establish an emergency fund first. With your income, it sounds like a base $1000 emergency fund should be sufficient. If you have kids, you might want to bump that up a little.

I completely (but respectfully) disagree with Pinyo’s comment about using a credit card for emergencies. That’s what gets people in debt and in trouble. Establishing a cash emergency fund is done to avoid debt. I would then recommend taking the remaining 11,000 – 12,000 and pay off the credit card and apply the rest to your student loan.

You’re in your early 30’s, and have a great income so you can should be able to build up a very comfortable retirement fund. Get rid of those debts though, as if he does get laid off and has trouble finding a job, you don’t need the extra hassle of creditors calling.

Let us know what you decide to do!

Readers, what do you think? Agree with any of us? Have your own opinion to share? Help Samantha out and share your thoughts by adding a comment!

15 Responses (including trackbacks) to “What should I do with tax refund? – Ask The M-Network”

  1. Anne Ferguson Says:

    I agree that putting money into an emergency fund is crucial in that that prevents using credit cards as a source of emergency funds, which sets up the debting cycle. I advise my clients to use the 1/3, 1/3, 1/3 rule. 1/3 goes to the past (credit card debt); 1/3 to the present (emergency fund) and 1/3 to the future (IRA). I believe the $1,000 rule of thumb for an emergency fund is way too low, even for a couple who have a good income. There are just too many unknowns out there, called “life happens,” which include a layoff, medical crisis, unplanned travel for a family emergency, etc. If there isn’t a sufficient emergency fund, then you’re forced to use your credit card, which puts you back into debt.

  2. Baker @ ManVsDebt Says:

    The amount she is getting back could very well be a loan. If she bought before January 1st, 2009, the credit is a 7500 interest free loan that is paid back in $500 chunks starting in two years. If she bought in the new year, well then it’s $8000 and it doesn’t have to be paid paid.

    Paying off your credit card debt and building a emergency fund is by far the best thing to do on one condition. That one condition is that you actually change your habits. If you are not going to cut up the credit cards or if you know you will be tempted to spend the emergency fund, you might as well dump the whole thing in retirement.

    Please don’t try to time the market though. No one has any idea on where it is going. Invest in the market when the time is right for you regardless of whether it’s up or down. For me, I wouldn’t think about investing until you’ve got the consumer debt knocked out and a decent emergency fund built.

    Whatever you choose good luck!

  3. Miranda Says:

    I like the idea of IRAs as well. You can contribute, get an emergency fund going and make an extra payment. It sounds like you are in great shape.

  4. MyJourney Says:

    “We have paid down the card a lot by putting 4K towards the card every month for the past 3-4 months.” They are paying $1,000 to the CC debt a week! That is a SICK amount…nice work.

    You have 0% to November – thats roughly 28 weeks away or ($285/week into the 8K debt). At $1000 a week you are sitting good and lookign to clear it up months before Nov. I would use this money to fund A retirement plan (the kind and tax year should be a different discussion).

    Remaining amoutn should be put into an ING emergency fund (ING because it is harder to get at).

  5. MITBeta @ Don't Feed the Alligators Says:

    I agree with Pinyo on this one. Fund the Roths since they will pay the biggest dividends over the long term and there is a limited window for contributing. Also, they can serve as a de facto emergency fund since you can withdraw the principle from these accounts with no penalty. Your monthly surplus gives you plenty of cushion without an emergency fund.


    1. Fund your Roths to whatever maximum you are allowed (you don’t say whether you’ve already made any IRA contributions for 2008…)
    2. Set aside money over the next few months to pay off the credit card.
    3. Create a good sized emergency fund.
    4. Fund your retirement accounts for 2009.

    Good luck!

  6. lorishaneck Says:

    ARE YOU KIDDING ME? A $13,000 refund and $8500 monthly take home pay?
    You shouldn’t have any money worries with that kind of money. I work at walmart and my husband just got bumped down to part time at his job(so that he can keep his insurance). We have to pay state and federal taxes every year and we both claim zero. We are doing okay, but we owe quite a bit on past medical bills and back taxes. We don’t have any credit cards. You people crack me up-you can’t tell when you are blessed. Maybe you are praying to the wrong God.

  7. Jody Says:

    Put it all in an emergency fund to be a safety net if your husband loses his job….there has already been one round of layoffs at his company so there is a really high chance that there could be more. Frankly, I would then add more money to your emergency fund – ideally 8 months of living expenses if you were to both lose your jobs. Then go after the credit card debt until it is gone and then look at retirement savings.

    Don’t count on being able to use a HELOC or credit cards to bail you out in case of a job loss…credit is being cancelled left and right so you may not have these are your disposal when you need them and who wants to be accruing debt at such a vulnerable time.

    Having a large emergency fund in this economy is truly the way to go.

  8. Kacie Says:

    I agree with the people who are saying to build up that emergency fund. You’ll be up a creek if you’re hit with even a small emergency.

    A severance package can’t be guaranteed in this economy. I don’t know what industry he’s in, but it seems no one is truly safe right now.

    Don’t bother with investing at all right now. Clean up your debt first, and then saving for retirement becomes a good thing to do. With your income, it sounds like you’ll be out of debt soon, so you’ll be able to save for retirement soon enough.

  9. tom Says:

    Ok 1000 emergency fund does not work for everyone. I live at home and 1000 for me is not enough because my monthly expenses almost top 1000.

    I say they should strive to have 6-12 months of savings. Meaning take whichever figure between 6 and 12, times your monthly expenses to determine your emergency fund.

    Clearly anything can happen in this market.

    Paying off debt works if you have little obligations, but what are you doing to do when you pay off one debt and now you lose your job or a big unexpected maintenance is needed? You go back to borrowing money.

  10. Doug T Says:

    My advice is both pertinent and quite simple. Certainly get those credit cards paid down dramatically (after all they are the root cause of your current debt situation) and start investing wisely in this bottomed out market place. My web page offers investment strategies that work and the best sectors of the market to be invested in. When you are invested in mutual funds and take control of these funds, many options are available including monthly redemptions if and when that option becomes necessary.

    Doug T….The mutual fund guy

  11. tom Says:

    @Doug T
    Are you coming on here trying to give us a sales pitch?
    And really, what kind of control do you have with mutual funds? Besides how much money you give to whoever who claims to do a good job with it.

    Also, what if the person loses a job and has bills to pay? They can either borrow or borrow from their retirement savings. So they got a choice between borrowing and paying interest or withdrawing funds and paying a penalty and possible taxes.

    And you call this sound advice?

  12. DDFD at DivorcedDadFrugalDad.com Says:

    I’m in the “Thirds Camp”. One third debt relief, one third saved, and one third splurged– hopefully on a time and money saver.