No one likes taxes. Well, some people do. Those people are weird (I’m looking at you, CPA friends!). Everyone, however, likes getting money back from the government after tax time. The question is, what should you do with it? Should you invest it? Pay down debt? Or maybe put a down payment on a Ferrari body kit for your Pontiac Fiero? Yes, that is a real thing, unfortunately.
If your monthly budget isn’t strained (you have at least 10% of your after-tax income left), then any of these things are reasonable answers. Well, the investment in your Fiero is questionable, but I would guess the people that would even consider it reasonable probably aren’t reading this article. If you have high interest rate debt (more than 5-6%), then paying that down seems obvious. Otherwise, investing the money in an IRA or taxable account would be the easy answer. However, ask yourself the following questions:
Am I living paycheck to paycheck? Do I have less than 1-3 months of liquid savings?
If so, I’d like you to consider something else. Put that money in a separate account, then create monthly recurring transactions to your primary account, where you can decide what to do with that money each month. If you have credit card debt, start with paying that down. This method isn’t as efficient, mathematically speaking, as dumping a lump sum onto your debt (since you are still paying interest throughout the year), but it gives you more flexibility over your cash flow when your budget is tight. It may also give you peace of mind that you have a little extra in savings, in case an emergency of some kind happens.
This brings me to my last point: there are a lot of situations where there is a “mathematically correct” solution, but money is a deeply emotional topic for most people. Even though it is technically better to invest excess cash than paying down low interest debt (like a 3.5% mortgage), some people just feel better working towards being debt-free. In these situations, I look for a compromise between the “correct” answer and the client’s emotional inclination that the client is comfortable with. I also run across individuals that experienced some market volatility and took their portfolio to cash, sometimes costing them hundreds of thousands of dollars in opportunity cost. Had they been working with an advisor, they would have had someone to be their emotional crutch to lean on, and to craft a solution and risk exposure they were comfortable with.
This article is for information and entertainment purposes only, and does not constitute investment advice. Kyle Thompson, MBA is the founder of Leetown Advisors, a fee-only financial planning and asset management firm. For further inquiries or suggestions, please email Kyle at firstname.lastname@example.org.