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Dr. Barbara O’Neill

By : Dr. Barbara O’Neill, Financial Management Specialist, Rutgers Cooperative Extension, [email protected]

It is very common for people to receive extra income during tax season. Almost 83% of tax filers in 2016 received refunds and the average refund was $3,120. Other types of cash windfalls include gifts, inheritances, settlements, contest prizes, lottery winnings, and life insurance proceeds.

How should a cash windfall be used? Like most financial planning questions, the best answer is “it depends.” Some key factors include a person’s age, income, financial goals, net worth, cash flow, and amount of existing savings and investments.

Let’s assume that you will receive a $2,000 tax refund. You plan to spend $500 and use the remaining $1,500 to save, invest, and/or better your financial situation. Below are eight suggestions to spend a cash windfall.

  • Fund an Emergency Reserve– Set aside money to provide ready cash when “stuff happens” in life (e.g., a sick child or car repairs). Three to six months expenses is recommended ($6,000 to $12,000 if expenses are $2,000 per month), but any savings is better than none. For liquidity (i.e., no loss of value if money is withdrawn), put this money in an accessible place such as a money market fund or bank savings account.
  • Reduce Debt- Repay the outstanding balance on high-interest loans or credit cards. To save the most money, start with debts that charge the highest interest. For example, many department store credit cards charge interest rates of 20%+. Paying off a 22% annual percentage rate (APR) credit card is like earning a 22% investment return: guaranteed, risk-free, and tax-free. PowerPay can help you create a debt repayment plan.
  • Invest for Retirement– Put your cash windfall in a Roth or traditional individual retirement account (IRA). Traditional IRAs may be tax-deductible in the year that a contribution is made while Roth IRAs are funded with after-tax dollars and earnings and withdrawals are generally tax-free. Taxpayers have until the tax filing deadline of the following year to fund an IRA for the previous tax year.
  • Invest in Yourself- Build your “human capital.” This is what economists call workers’ knowledge, degrees, experiences, and skill sets and a cash windfall can be used to maintain or improve it. Examples include paying for credits for a college degree program and taking courses or going to conferences for career advancement.
  • Invest in a Child-Add to the college fund of a child or student. Depending on the type of investment that you make, you may be able to save on federal and/or state income taxes.
  • Remodel Your Home– Consider using a cash windfall to make a small home renovation such as new carpeting, flooring, or bathroom fixtures if you plan to stay put for a while. If you plan to move soon, use the money for cosmetic changes that will increase your home’s resale value (e.g., new doors and landscaping).
  • Open a Mutual Fund Account– Consider a mutual fund for broad diversification and professional management of the fund’s investment portfolio. Many mutual funds allow investors to open an account for $1,000 to $3,000 (or less) with $25 to $100 subsequent minimum deposits.
  • See a Financial Advisor- Go prepared for an appointment with a list of questions and copies of relevant documents (e.g., copy of tax return) to save time (and, therefore, money). Windfalls can be well spent by seeing a financial advisor to get answers to your questions and direction for the future. Many financial planners charge hourly rates like lawyers do and some work exclusively with middle-income households.

Consider combining two or more of the ideas listed above. For example, 40% emergency fund, 30% home improvement, and 30% debt reduction. It is also perfectly fine to take your time to decide what to do with a cash windfall. Simply “park” this money in a money market fund or bank savings account until you develop a plan.

In summary, an extra $1,500 or $2,000 or so is certainly not enough to quit a job for, but it is enough to provide significant financial benefits. Whether you choose to invest this money in your home or yourself or a child or a mutual fund, carefully spend any extra cash that you receive. A cash windfall is a wonderful gift. Use it wisely.