Monday, October 16, 2006

How to Spend Your Next Tax Return (Part 1)

Tax return time is nigh; by year end through the end of first quarter 2007, Americans or dwellers of this hood would be seeking out money back guarantees from Uncle Sam. This yearly ritual is a kill time for retailers and credit card companies. Consumers for the most part spend their tax returns to get that Patio they badly wanted, or that flat screen TV they couldn’t afford at Christmas but bought anyway on their high interest credit card which they pay back. But this strategy is hardly the best way to spend a hard earned return, which is basically zero interest money you gave to Uncle Sam for one year. The average tax return has risen by about $200 to $2500 annually in the last couple of years. This means a lot of cash in the hand of consumers that is either spent before it was gotten or is not planned for.

The danger of anticipatory spending or unbudgeted spending is usually the guilt that sets in the second quarter after a tax return is badly spent with the promise to do better next year. To scale this guilt trip, a simple rule of the thumb need be applied to tax returns. This has to do with what you should do and not do with tax returns. Indeed, if tax returns are a bad deal from government (since it is a sub inflation rate loan you gave to Uncle Sam), then it behooves on you to ensure you put the money somewhere it would yield a minimum of inflation plus some in the next coming year and ensue the one year capital gain loss is made up for rather quickly. The good thing of course is that there is no lack of good investment vehicles to put your money into, but first the rule of the thumb.

To get into the nitty-gritty of tax returns, we must first trace the source (more on tax credits read hyperlink). Fifty percent or more of annual tax returns is a direct result either education related credits (education spending/deductibles, Hope Credits, education loan interest deductibles) or real estate tax credits (mortgage interest credits, real estate investment credits). What this means simply is that tax benefits from primary home ownership and being in school constitutes a sizeable chunk of tax returns. This leads us to the rule of the thumb for spending tax returns christened “Cash in Hand Rule” by yours sincerely. It simply states that after 10% discretionary spending (which you can use to spoil yourself and your loved ones); half of your tax returns should be put into paying off the principal amount of your mortgage loan and another half into your retirement account preferably your IRA. Of course what you do with your money is still entirely your business; but be wise.

The reasons for this rule are obvious: paying down your principal mortgage amount will reduce your loan repayment term (see mortgage calculator to find out by how long). This in turn will reduce your long term loan interest amount which is the real cost of your mortgage and indeed your home. Hence, using the money you gave interest free to Uncle Sam, you buy down the interest rate of your home by reducing your principal. Indeed, in one fell swoop you have nearly recovered the lost annual investment in Bank Du Washington DC. The idea of investing in your IRA is very obvious: you are investing in yourself and your future; more on what to invest in, in the next contribution on this page.