A Tale of Tax Refunds and Compounding Returns

Posted on May 23, 2012 by

A Tale of Tax Refunds and Compounding Returns

Many people are likely still waiting for their federal income tax refund in the mail, or perhaps it just arrived. There’s often temptation to spend the money on things we’ve been waiting to buy — whether a much-needed vacation or a new personal gadget.

But a much better plan can be to put that money toward the future. Investing it, for instance, in an individual retirement account allows you to set aside a nice chunk of money that has the potential to grow into a nice retirement savings fund.

Here’s how this can work:

Let’s think about a hypothetical person – we’ll call her “Rachel.” At age 35, Rachel has only $25,000 saved up for retirement in her workplace 401(k) – the national average, according to the Employee Benefit Research Institute. However, according to EBRI, the average worker today will need at least $900,000 saved up by age 65 in order to retire securely.

Rachel overpaid federal taxes through her payroll, and so Uncle Sam gave her a refund of $3,000 that it deposited in her bank account. Rachel is ready for a shopping spree. But she decides instead to put that $3,000 to help bolster her retirement savings.

After consulting her financial advisor, Rachel puts the money into a Roth individual retirement account. This means she gets no tax break for her contribution, but that $3,000 will grow tax-free and she’ll never have to worry about paying taxes on it again.

Her advisor suggests she put the money into a well-diversified mutual fund, to minimize her investment risk.

Rachel leaves that $3,000 in her Roth IRA until her retirement 30 years later at age 65. In fact, Rachel contributes every tax refund she gets for the next 30 years – for simplicity sake, we’ll assume it’s $3,000 every year. (The average tax refund amount is currently about $3,000, according to the Internal Revenue Service.)

What happens to Rachel’s retirement fund over those 30 years? Rachel herself contributed $3,000 a year, or $90,000 in all. But thanks to the magic of compounding – the ability for an investor to reinvest their earnings and start generating returns on those reinvested – that $3,000 annual tax refund grows substantially over the 30 years.

Assuming a 6% average annualized return on investment (a fairly safe assumption in a diversified account with stocks and bonds), Rachel would have a little more than $250,000 in her retirement fund after the 30 years – or roughly triple the $90,000 in tax refunds she invested.

Since Roth IRAs never require withdrawals during your lifetime, she can continue to benefit from years of compounding and that $90,000 in contributions. If Rachel does make withdrawals in retirement, that $250,000 in her Roth can be withdrawn tax-free.

Takeaways

Here are some takeaways from Rachel’s story that can help you maximize your tax refund:

Think differently. Your tax refund isn’t really a “gift” from Uncle Sam. It’s overage you paid into the tax system through your paychecks. So it’s really a portion of your income being refunded to you. While it’s OK to splurge a little bit, Rachel’s story shows how investing it can provide much greater value over many years.

Start early. Investment compounding becomes more powerful over the years. So the earlier you start investing your tax refunds, the more time they have to grow.

Consider Roth. Many people have a “traditional,” tax-deferred 401(k) plan through their workplace. But given the real possibility that federal taxes will go up and be higher when you retire, a Roth allows you to pay today’s lower tax rates on your savings so you don’t have to worry about them in the future.

Diversify. Like Rachel, make sure to spread your savings across a broad mix of investments, so you’re not overexposed to one type of stock or bond. Typically you want the majority of your savings to be in a mix of U.S. and international stock funds or exchange-traded funds while you’re still young, but slowly build your stake in bonds and other fixed-income investments as you get older and your investing horizon shortens. An easy way to diversify is by investing through a “lifestyle” or “target date” mutual fund tied to your expected retirement year that automatically becomes more conservative as you get older.

Kelly Spors writes for the leading Roth IRA and online retirement planning resource, RothIRA.com. She is a former Wall Street Journal reporter who has also written for The New York Times, Entrepreneur magazine, SmallBizTrends.com and Yahoo!. Kelly specializes in personal finance and small business issues.

The Financial Tales Response

The preceding Tale submitted by Kelly is one that readers may find timely.  Many of you have recently received or will soon receive a tax refund and many may be wondering what to do with it.  Remember you only have 3 choices.  You can invest it, spend it or some combination of the two.  Kelly provides a vivid example of what might happen if you invest it.  This tale teaches us about saving vs. spending and shows us the power of compounding.  In her tale Rachel only saves $3,000 per year or $90,000 total over 30 years but it grows to $250,000 if we assume a 6% interest rate.  This isn’t chump change for what I consider painless investing.  This might be something that works for you.  You can refer to A Compounding Tale for a better understanding of the power of compounding.

I have two areas of possible disagreement with Kelly’s Tale however.

The first possible disagreement is I can’t tell from her writing if she is recommending a “Target Fund” or Lifestyle Fund” or just using it as an example.  In any event–Financial Tales does not recommend these types of mutual funds under any circumstances and at any time in a person’s wealth cycle.  When building wealth they are expensive, they underperform and allocate entirely too much money to fixed income way too early in a person’s life.  Furthermore, if you are no longer building wealth they are still expensive, underperform and allocate entirely too much money to fixed income.  We suggest you avoid these types of formulaic and expensive types of investments with your portfolio.  If Kelly were to have substituted a Total Return Fund or Balanced Fund that is on our approved list we would have been much happier.

The second area of possible disagreement stems from “Rachel” consulting with her financial advisor.  The advisor recommends a Roth IRA which seems like a good mechanical idea but then doesn’t take control of the situation and either a) lets Rachel do her own investing by potentially letting her invest in the dreaded Target Fund or b) may have actually recommended it him or herself.  In either event it is important to our readers that they understand that you either hire a competent advsior and have a way to distinguish their competency as we learned from An Expert Tale or you must develop your own competency.  It is too easy to read a Tale such as this one and assume the subliminal message of “an advisor that recommends a mechanical idea is also a competent advisor and Target Funds are OK” when in fact mechanical ideas are the least important aspect of an advisor’s job.

If you are interested in the types of investments we at Financial Tales recommend, feel free to contact us and we will get in touch with you shortly.

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Three Tales of Debt Consolidation Programs

Posted on April 16, 2012 by

We are pleased to post this tale because it was so well written and balanced.  While the tale obviously endorses the case for debt consolidation we at Financial Tales want to make sure you the reader does not think we do.  In fact, we are generally opposed to debt consolidation in that to us it is nothing more than a “Band-Aid” and does not cure the over-spending disease.  However, we recognize that sometimes before you can cure a disease you must seek less than optimal methods.  Debt consolidation is not the cure.  Only you can cure yourself.  We urge our readers to read A Green Tale to find a cure.

Three Tales of Debt Consolidation Programs

These are the stories of three different people who considered debt consolidation as an option to manage their debts- Scott Salva, Susan Smith and Daniel Jones. All three people found there’s no substitute for doing research and legwork when it comes to debt consolidation- they are vital steps in not only choosing a debt consolidation program, but also finding out if debt consolidation will work.

Scott Salva’s Tale of Debt Consolidation

The Christmas season did it. Lulled into complacency by credit card transfer deals, the existing debt seemed to be safely parked. The news said the job market was improving. All the stores were running excellent sales, and the temptation to pull the credit cards out and buy gifts -for others and for Scott was too strong. What slipped through the radar was that all those zero interest balance transfers carried transfer fees that actually increased the total amount owed. When the January statements came in, the numbers were shocking.

Sitting down and taking inventory of all the debt, it was obvious that even with prioritizing the amounts and developing a schedule of payments, it would take years to resolve the balances. In the meantime, temptation would surely come calling again-the cards would come out of the wallet. No matter how many promises he made himself to pay with cash only, interest would keep adding up in the interim, and those monthly credit card payments were killing his household budget.

His debt situation had reached the point where life decisions were being deferred. Moving to a new home was unthinkable even in the presence of low interest rates and equally low real estate prices. His credit rating was getting shaky enough; in fact, that he thought a new car loan might be out as well. Debt consolidation programs were always seen as suspicious of a “scam,” but the time had come to evaluate such programs with a truly critical eye. Were the offers valid and if so, could they help?

Education was the first order of business. Finding companies offering debt consolidation programs was no harder than running an Internet search. The idea was to find a company that seemed open and transparent with the plan details. He cross-referenced against complaints at the Better Business Bureau’s website, and the list began to narrow down quickly. Next the phone calls began. Any company that seemed reluctant to answer detailed questions was eliminated as a potential.

Essentially all the companies were offering the same thing: to negotiate with his creditors to lower existing balances and to extend the life of the loans with lower interest rates. The final amount would be consolidated into one balance, with one monthly payment to be distributed among my creditors. The company with a clear BBB record that offered everything in writing with a clear schedule of payments, and that answered all his questions in detail, “won” in the end.

So, a year later, what’s his status on the debt? It’s been reduced by more than a third, right on schedule with the realistic 2-3 year debt resolution plan outlined in his company’s literature. The monthly budget is starting to loosen up. Yes, he has made sacrifices to make that single monthly payment, but the amount doesn’t change, and because of that, it can be treated as a fact of life. Seeing the total debt amount shrink monthly made it easier for him to keep the credit card in the wallet, so overall spending habits have also improved.

The debt consolidation company also offered free financial counseling and literature that have been useful for him. Taken altogether? This has been a positive experience for Scott. Without careful planning and evaluating multiple companies, that might not have been the case.

Susan Smith’s Tale of Debt Consolidation

Susan Smith was feeling overwhelmed by her debts. Because she was recently laid off, she could no longer make the minimum payments on her credit card bills, car loans, mortgage, and student loans. Despite the fact that she was able to pay all of her bills while she had a job, she had already run through most of her savings, and was struggling to pay her bills.

She began to look into her options with debt consolidation programs. She soon discovered, unfortunately, that she wasn’t a good candidate for debt consolidation.

She found out that she would need a steady source of income to qualify for the loan. The payments she received from unemployment insurance did not qualify at some banks. Next, she discovered that not all of her loans would be eligible for consolidation. Her mortgage was not eligible for the loan because her house was underwater. Her car loan was also considered to be non-eligible for consolidation.

Because of all the roadblocks, she decided not to pursue debt consolidation. She’s looking into other options, and hoping she finds a job soon to pay off her bills.

Daniel Jones’s Tale of Debt Consolidation

Daniel Jones was also considering debt consolidation. While he was able to make his monthly minimum payments on his debt, he felt as if he was never getting ahead. His budget didn’t let him pay much extra towards his debts, and he thought that debt consolidation might be the answer.

He started his research by doing an internet search for debt consolidation loans. His search turned up thousands of results. As he began the long process of researching companies, however, he began to have some reservations. Several companies didn’t return his calls, many wanted him to pay application fees, and he found many problems with companies when checked on them through consumer watchdog groups.

At the end of his research, he believed that he just couldn’t find a company that he trusted enough to handle his debts. The market was too full of companies that were poorly managed or seemed to be scam operations. Ultimately, Mr. Jones also decided he would try to find another way to manage his debt.

About the Author

This is a guest post written by Suzan Bekiroglu. Ms. Bekiroglu is a published author, freelance writer, and editorial consultant for secureloanconsolidation.com. After receiving a Bachelor of Arts degree from the University of South Florida, she faced the mounting obstacle of paying over $24,000 back in student loan debt. Thus, she became determined to eliminate the debt and become very knowledgeable about money management.  She seeks to educate others with tips on managing student loans and other kinds of debt, as well as in general personal finance and money saving tips.

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A Tale of Credit Card Debt Settlement – A Financial Joyride

Posted on April 4, 2012 by

A Tale of Credit Card Debt Settlement – A Financial Joyride

With the present slothful economic state in the US, just about everyone has a nodding acquaintance with the D-word debt, although a particular class of people in the US is intimately associated with it. Debt can creep into your personal thoughts and wreak havoc and even spoil relationships. Over the past few years, I’ve been in and around credit card debt and when I heard about this personal finance blogger who invited success stories of how people squelch their debt load, I couldn’t resist the temptation of sharing my experiences of drowning in a sea of high interest debt and how I settled my way out of it. Though there was an abundance of debt settlement options that flooded by mailbox, I decided to negotiate my debts on my own by taking resort to some DIY steps. Here’s how I managed to get out of the high interest debt trap.

How I brought myself into this hapless financial situation

Since I started sharing my personal experience with debt, let me tell how I landed up in this gross financial mess. My first job was that of a CCE or a customer care executive where I used to spend 9 hours answering queries of credit card holders. From there I changed to various sectors within the same company including the credit card fraud department. I used multiple cards and my habit of impulsive shopping made me whip my plastics for every purchase and this is how I ended up in a soup. Thankfully, my job helped me equip myself with enough experience and knowledge on getting out of debt on my own and deleting my financial worries. I owed a total amount of $60,000 on revolving credit card debt and these are the steps that I took to settle them.

Debt settlement steps that I took to eradicate my fiscal worries

A person who has amassed a huge amount of debt on multiple credit cards will think that defaulting on the payments would just subject him to penalties and late fees amounting to 25-30%. I too foolishly thought that repaying the balance with the additional fees would change my life but unfortunately it didn’t. It rather set the stage for my vengeance against the soaring credit card debt level. Read on to know how I succeeded with DIY debt settlement.

  • I made a list of the debts: Though some people may find it foolish to sit with a pen and paper to calculate their debts, but I did it! I sat with a pen and paper and jotted down the total debt amount, the principal balance, the interest rates and the due dates on each account.
  • I set goals and started saving money: Before opting for DIY debt settlement, I knew that I had to grow a fund by saving at least 10% of what I made in a month so that I would be able to repay the remaining amount on time. Therefore, I pinched my pennies for a long time and started saving money like never before.
  • I negotiated with my creditors: Though I used to feel shy meeting with my creditors and telling them about my financial hardship, yet I took this step as they’re the best people to help me out. I told them about the fiscal hardships that I’m going through and convinced them that I will pay back on time once they waive off a certain portion from my debt amount.
  • I prepared a post-settlement budget: Yes, this is a very important step that supported my request and helped me in convincing my creditors. The well-planned budget made the creditors understand my urge to repay the debt if they settle for a lesser amount.
  • I came up with a settlement amount and made the payments: Last but not the least; I came up with a settled amount that benefitted both me and my creditors. As they agreed after a small discussion, I started making the payments of the remaining amount and within 24 months, I became debt free.
Following the debt reduction steps mentioned above, my debt amount reduced to $45,000 and it soon seemed that a plethora of options opened up for me again. Within a period of about 2 years, I was able to exterminate my entire debt burden. I gradually started owning my bucks and sought things that are valued. This was my amazing financial joyride through which I got back a firm grip on my personal finances.

Author:

Jenney Roberts is a  writer for various finance related Communities including Debt Consolidation Care. She is a financial writer by profession and has specialization in dealing with financial problems and its solutions.  She is well equipped to write articles on debt consolidation, savings, planning, frugality, debt settlement etc.

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