The Tax Refund Windfall Waterfall

Tax season is upon us once again, and for many Americans that means a tax refund is coming your way. So, what should you do with that one-time cash windfall? Well, you’ve come to the right place! This blog post outlines my strategy for deciding how to best utilize cash windfalls.

Of course, I have not met anyone yet who needed advice on how to best spend a tax refund. People seem fully capable of spending money with no help from me! So, instead, I focus on tips for not spending it. If you decide to save some of your tax refund, then this is the post for you.

Before we get into what to do with a tax refund, I need to get something off my chest: Personally, I am not a fan of getting a large tax refund. Receiving a bunch of cash from the feds does not necessarily mean that I have had a small tax bill. It just means that I have already paid in more than was necessary to cover my tax bill.

Why I don’t like Tax Refunds

Let’s say you rent an apartment. The rent is $700 per month, but for some reason you pay your landlord $1,000 a month for a year. Then, you do some math and find that you have paid $12,000 for the last year, but the total bill was only $8,400. So, you tell the landlord you want a refund of $3,600.

The landlord is just giving you back money that you were dumb enough to overpay. It would be much better to just pay the $700 per month and not have to worry about collecting a refund. I see giant tax refunds the same way.

If you are consistently getting massive refunds year after year, you can fix that by simply filling out a new W-4 form and giving it to your employer. Your take-home pay will go up and your tax refund will go down.

However, there is one major caveat: I do not like overpaying my taxes because I want to put that money to good use throughout the year. For those people who do not trust themselves with the extra cash and like the government to hold on to it for them so they at least have something to show for themselves once a year, then a large tax refund is not a bad plan.

*WARNING – shameless book plug ahead!*

Of course, if you want to break the cycle of spending everything you have and living paycheck-to-paycheck, then check out Part 1 of my book: Managing Cash.

Treat Your Finances Like a Small Business

The first step in my strategy to become financially independent is to separate my income from my spending. I go into a bunch more detail in my book, but here are a few highlights:

First: all of your revenue from all sources should go into an account that is not the same as the account you use to pay your everyday expenses. I prefer for all revenue to go into a savings account and I pay myself a regular wage out of that account.

Second: only change your withdrawals from that revenue account once or twice per year, and never in the same month as a large windfall. So, if you receive a big tax refund in April, let it sit there until May or June before deciding what to do with it. Get used to the feeling of having money. I review the balance in my revenue account in June and December each year.

So, have your tax refund direct-deposited into the same savings account that you use to collect all of your revenue. Then, let it sit for at least a month so you can see what it feels like to actually have that money. Then, during a regularly-scheduled review, you can decide how to best utilize the excess balance in that account.

Okay, now that I have gotten that out of my system… let’s get into the meat-and-potatoes of this post: how do you decide what to do with an infusion of cash?

Cash Windfall Waterfall

I like to use a decision waterfall. Basically, I have six buckets that I need to fill up with cash and I have prioritized them. I will fill the first bucket to the top before moving on to the second bucket. Then, when the second bucket is full, I move on to the third. And so on…

Cash Windfall Waterfall

Bucket 1: Pay off high-interest debt

Money is precious. If you borrow other people’s money, they will expect to get paid. If you haven’t given them enough evidence that you are incredibly likely to pay the money back (aka good credit), then they will require you to pay more for the privilege of using their money.

It can be very difficult to prioritize between paying off high-interest debt and funding emergency reserves (which, you’ll see is bucket 2 below). For me, I focused on paying off credit card debt first because I wanted to stretch my dollars further. If there was an emergency after I had paid down my debt but before I had built up my reserves, I had the option of putting new spending on the card I just paid off to avoid catastrophe.

I have noticed in my conversations with people who are just starting to focus on becoming financially independent, that it is easy to confuse the monthly payment with the cost of borrowing. For example, a $2,000 credit card balance may have a minimum payment of $30. Some people confuse that $30 as the cost of the debt. It is not.

A portion of that $30 goes to interest and the rest goes to pay down the debt. Your interest rate determines how much of that $30 goes to interest, and that is the cost of the debt. If the interest rate is 18%, then the annual cost of that $2,000 debt is $360, which is $30 per month. So, you could pay $30 per month for eternity and never pay off the debt. Gross.

But, if the interest rate is only 5%, then the annual cost of the debt is $100 (or $8 per month-ish), so nearly $22 of that $30 payment will go to paying down the debt. And, the next month the portion that goes to interest will decrease because you have paid down some of the principal.

So, how do you decide whether to pay down debt or build up emergency reserves? For me, I like to eliminate all unsecured debt first (aka credit cards and personal loans). Paying off, car loans and mortgages can wait until after I have some money in the bank. Here’s why:

Using that $2,000 example. If my credit card interest rate is 18%, then that loan will cost me $360 per year. If I use $2,000 from my tax return to build my savings and receive 1% interest, I will get a whopping $20 in a year. So the net cost of that loan plus savings is $340.

But, if I pay off the loan and put nothing into savings, the net cost is $0. I would much rather pay $0 than $340. Plus, when I have the loan paid off, I have now freed up $30 per month in payments I no longer have to make.

Car loans and mortgages generally have much lower interest rates. So, while they are not free, the cost of that $2,000 balance is less. Using the same example as before but with a 5% interest rate: if I use the $2,000 to build my savings, I will get $20 in interest per year, and I will have to pay my lender $100 per year for that $2,000. So, the net cost of the loan plus savings is $80 per year. I think that $80 is a reasonable price to pay for the privilege of using someone else’s $2,000 for a year.

One big warning about paying off credit card debt: if you struggle to stay out of credit card debt, then just paying off your current balances is not enough. If you want to stay out of high-interest debt, then you need a system to keep your debt in check. I outline my approach in my book in Part 2: Managing Credit. (so many shameless plugs! haha)

Bucket 2: 3-6 months’ emergency reserves

Okay, so now you’ve decided which debt to keep and which to eliminate. If there is money left in your tax refund (or other financial windfall), then you can jump-start your progress on escaping the paycheck-to-paycheck cycle.

The first step to escape living paycheck-to-paycheck is to have enough cash in savings to cover 3 to 6 months of expenses. When I receive a lump-sum of cash from any source, the first thing I do is check to make sure I have my emergency reserves fully funded.

Before you can do this, you need to decide exactly how much you want your emergency reserves to be. Go to your kitchen table, get a piece of paper, use the calculator on your phone, get some pay-stubs, and figure out how much money it would take to replace your income for 3 months.

Seriously, I’ll wait.

Go.

Do it now.

Do you have it?

Okay, round that number up to the nearest thousand.

That is the minimum emergency reserve you should have in savings.

If your tax refund is not enough to boost your savings to that dollar amount, then the decision is easy. Every penny goes to savings.

If you want tips on how to get your emergency reserves up and stop living paycheck-to-paycheck, be sure to check out Part 1 of my book. (another shameless plug, I know)

Bucket 3: Non-Retirement Investment Account

A lot of folks skip this step and move straight into retirement accounts. That can work, however I like to have a second backup beyond my emergency reserves.

The only difference between retirement accounts (IRA, 401(k), Roth, etc) and non-retirement accounts is how they are taxed. So, the only reason to use a retirement account is to take advantage of the tax treatment.

If you get into a bind and have to break the rules of the retirement account, then you’ll be slapped with a penalty… which completely defeats the purpose of the account.

So, I only put money into my retirement accounts that I am 100% sure I will not need until after I’m retired. Which means, I need to have enough money to pay for things like down payments on vehicles, vacations, house down payments, college, etc etc etc… outside my retirement accounts.

The dollar amount necessary for non-retirement accounts is different for everyone. So, you may have to do some thinking on this bucket before moving on to the next one. And that’s okay. The most important thing is to make a plan for yourself that you can stick to.

Bucket 4: Fully Fund a Roth IRA

I love the Roth IRA. Used properly, it can seriously reduce the amount of tax you pay in your lifetime. Seriously.

Roth IRAs basically allow you to pay income tax on money today, and then invest that money, let it grow, and never pay taxes on that money again. Never. No matter how big it grows.

I personally think that since the Roth IRA is such an amazing deal for taxpayers that at some point the government is going to have to change the way Roths work. They are just that good of a deal. So, my approach is to put as much in a Roth as I can responsibly afford as often as possible. So, after I have funded my emergency reserves and funded my non-retirement account, I load up my Roth IRA.

Bucket 5: Fully fund a 401(k)

For nearly every taxpayer in America, the tax refund has run out way before this bucket. According to fool.com, the average tax refund in 2016 was about $2,700.

The average household income in the US is a little over $50,000, so a three-month emergency reserve would be over $10,000.

For most tax payers, the maximum Roth IRA contribution is $6,000.

Therefore, after topping up emergency reserves and non-retirement investments, then fully funding a Roth… there will be very few tax payers who make it to Bucket 4. However, this waterfall works for all kinds of cash infusions (inheritances, court settlements, etc).

If I still have cash left after fully funding my Roth, I turn to my 401(k). For most tax payers, the contribution limit for a 401(k) is $18,500 in 2018. So, a married couple could, hypothetically add $37,000 to their 401(k) accounts each year.

However, contributions to 401(k) accounts generally have to be made through payroll deferrals. So, you can’t write a personal check or have your tax refund deposited into your 401(k). That doesn’t mean you can’t put that money in there though!

Let’s say you received a $15,000 lump sum that you want to put into your 401(k) and that you make $5,000 per month. I would put the $15,000 into savings, go to HR and have them put 100% of my income (or whatever their maximum is) into my 401(k), and set up automatic transfers from my savings to my checking on what would have been my paydays. That way my cash flow does not change, I’m just changing the source of my paycheck. Then, after three months, have HR change my 401(k) contributions back to whatever they were before and put everything back to normal.

And, just like that, it’s as if I transferred that cash into my 401(k).

With a piece of paper, some time on your phone’s calculator app, and a bit of thinking, you should be able to calculate a way to make this work for your personal situation.

Bucket 6: Back to Non-Retirement Accounts

If your lump-sum cash infusion is more than you can add to your Roth and your 401(k), then you have pretty much exhausted all of the tax-preferred options that are readily available to you. If that is the case, I generally use my non-retirement accounts to catch the rest of the money. Sure, I do not get special tax treatment, but that’s okay.

Important note

I’m sure you noticed that I put the 401(k) after the Roth IRA on this waterfall. That is because this waterfall is just for lump-sum infusions of cash. In Part 3 of my book there is a prioritization list just like this one for regular cash flow. That list shows that I contribute enough to my 401(k) to get the full company match before I start contributing to my Roth because I try to never walk away from free money!

So, I contribute enough to get the full company match from my 401(k), then contribute the max to my Roth before I go back to my 401(k) because the tax treatment of the Roth is just so amazing. All of the details are available in my book.

I hope this helps! Comment below with your tips and tricks – or send me an email any time!

If you liked this tidbit of advice, then you will love my book, Practically Independent: Practical Advice to Become Financially Independent. Available in paperback and e-book on Amazon.com

Practically Independent: Practical Advice to Become Financially Independent. By Jay Rigler
Order now at Amazon.com

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