Start building nest egg, invest that tax refund

Modest yearly investment in a stock fund could yield $1.1 million in 40 years

Your Money

April 09, 2006|By GAIL MARKSJARVIS | GAIL MARKSJARVIS,TRIBUNE MEDIA SERVICES

If you have vowed many a time to start saving, or to save a little more than you already do, your tax refund presents a great chance.

Americans often have their refund spent before it ever ends up in their mailbox or bank account. But if you can resist spending the money, it can make a big difference for your retirement or children's college fund.

Although many experts say it's better to reduce your withholding and invest the money throughout the year, the average tax refund totals about $2,100. So consider what that could do for you: If you invest it in a stock mutual fund, and it grows the way the stock market has historically, you could have $95,000 in 40 years.

Not bad for $2,100. But now look at this: If every year for the next 40 years you invest another $2,100, using a well-diversified stock mutual fund, you could have about $1.1 million.

The key step

People think it's more difficult to build up a sizable nest egg than it is. The key is to stop procrastinating or feeling defeatist.

In January, the Consumer Federation of American and the Financial Planning Association surveyed Americans about saving and found that only 26 percent of adults thought they could accumulate $200,000. About 21 percent said the most practical way to accumulate a few hundred thousand would be to win the lottery.

Of course, it's more likely you will be hit by lightning than accumulate the savings you need from a lottery win.

So put that refund to use. If you are debating how to deploy it, here are some ideas:

Pay down debt

Often people use refunds to pay off bills, and no one can argue with that. It's actually the best way to invest in your future, because it's a sure thing.

If you are paying 14 percent in interest, and cut down the period you will be paying interest, you are saving real money. You can save that extra money for a house down payment, invest in an individual retirement account or 401(k) for retirement or set it aside to pay for the children's college education.

Imagine you have a $7,000 credit-card balance. If you pay $175 a month, it would take you four years and $2,484 in interest to get rid of $7,000 in credit-card debt.

But after using your refund to lower your balance to $4,900, you could keep paying $175 a month. Then, you would cut your total interest to $1,067, and you would be free of your debts in less than three years.

Do the calculations yourself at www.bankrate.com.

Half and half

The trouble with paying off credit cards is that it often doesn't feel like you are getting anything for it.

When you are saving for retirement, you see the money growing each year, and it can be invigorating when you see your original $1,000 turn into $1,500 and, years later, $10,000 and then finally $45,000 after 40 years. When you invest money and watch it grow, you feel like you are actually getting somewhere.

But if you are a person who can't ever seem to wipe out your credit card debts and consequently keep putting off saving, you might need another approach to make progress.

So here's your opportunity to do both: use half the refund to pay down your credit-card bills and invest the other half for retirement.

If you are in your 20s, and invest $1,000 now, and another $1,000 every year until you retire, and you average a 10 percent annual return on the money, you will have about $532,100 when you retire. But if you tell yourself there is plenty of time and you can wait, you would accumulate only about $198,400 if you didn't start investing $1,000 a year until you were 35.

Saving early gets you further because of the magical power of compounding, or earning interest on interest. Try the compounding calculator at www.moneychimp.com to see the impact of when you start saving and the various returns you can earn.

Notice why you wouldn't use a savings account: Earning just 1 percent in interest isn't going to get you far.

Retirement and college

If you have been debating between starting a college fund for your children or saving for retirement, you could take the same half-and-half approach - putting $1,100 into an IRA and $1,000 into a college fund.

Investing $1,000 in a college savings plan for a baby, with no new contributions, could provide about $4,000 by the time he or she starts college. I'm assuming that the money would earn about 8 percent on average a year in mutual funds that use stocks and bonds, which might be a little ambitious.

Perhaps $4,000 doesn't seem like much, given the current cost of more than $60,000 for tuition, room and board for four years at a state university. But now consider what you could have if you plopped another $1,000 into a college savings plan each year for the next 18 years. With that same 8 percent return, you could have about $44,400.

As you weigh the possibilities, consider the cost of waiting. If you started investing $1,000 a year for college when a child turns 10 and earned an 8 percent return, you'd have only $13,300 by the time college tuition started rolling in.

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