Uncle Sam has stepped up to the plate to help you confront a bad habit.
This year, for the first time, taxpayers who receive a federal tax refund will be able to tell the IRS to send the money via direct deposit into any existing account at any financial institution.
Expanded Options
Up until now, your only refund choices were a hard check that took weeks if not months to materialize in your mailbox, or direct deposit into a checking or savings account. The problem with those two options is that, for many people, it was far too easy to cash the check or otherwise quickly spend the money.
The new IRS policy now helps you circumvent that spending temptation by sending the money straight into an investment account. In fact, the IRS is also ready to help your diversification efforts: The new policy allows you to deposit your refund into up to three different accounts at three separate financial institutions.
Don't Miss Your Chance
I encourage anyone who's set to receive a refund this year to sign up for this great option. And if recent history is a guide, that means plenty of you.
For the 2005 tax year, the IRS issued 100 million refunds that totaled more than $217 billion. Recently, in the early stages of the 2006 tax year filings, the IRS reported that refunds are averaging more than $2,700 each.
Put that $2,700 into a Roth IRA invested in a low-cost index fund or ETF for the next 30 years and you're looking at more than $29,000 (assuming an average annual return of 8 percent).
Lemons into Lemonade
As pleased as I am that the IRS has come up with this new system, it's just making lemonade out of lemons. The fact is that tax refunds are a sign that you're wasting money.
As I've said umpteen times before, a refund is nothing more than the federal government returning money to you that you should never have paid in the first place. So what's the big deal if you overpay and then get a nice juicy refund? Well, the entire time the money was in Uncle Sam's coffers and not yours, you lost out on potential earnings.
Collectively, U.S. citizens gave the federal government a $217 billion, interest-free loan during the 2005 tax year. That works out to roughly $6 billion in lost interest based on a typical 3 percent money market yield in 2005. That's just a colossal waste of money.
Do yourself a huge financial favor and break your refund habit. If you're set to receive a 2006 refund, aim to make it the last refund you ever get. Adjust your 2007 W-2 withholdings or your estimated tax payments so that you end up paying just enough to Uncle Sam, but not too much.
Three Steps for 2007
As for this year's refund, here's what I recommend you do:
• Decide what investment account you want your refund sent to.
As I mentioned earlier, if you're eligible for a Roth IRA that's your best investment option. And, as a reminder, the income eligibility limits were raised for the 2007 tax year: Single filers with modified adjusted gross income (MAGI) up to $114,000 and married couples filing a joint return with MAGI as high as $166,000 are eligible to contribute to a Roth.
(To contribute the annual maximum of $4,000 -- or $5,000 if you're over 50 -- those MAGI levels must be below $99,000 and $156,000, respectively.)
If you don't currently qualify to contribute to a Roth, I recommend investing in a non-deductible traditional IRA with the goal of converting it to a Roth in 2010, when a tax-law change will allow anyone regardless of income to do Roth conversions. I covered this strategy in detail a few months ago.
• Fill out IRS Form 8888 and attach it to your federal tax return.
This is a simple one-page form in which you give the IRS the account information and routing number of the financial institution where you want your refund deposited.
• Make sure you complete the paperwork at your financial institution that makes it clear what tax year the refund direct deposit is to be earmarked for.
Remember, you have until April 17, 2007, to contribute to fund a 2006 IRA. Or, you can use the refund money to fund a 2007 IRA contribution.
Simplify Your Options
I realize that for many people the stumbling block to opening an IRA account is that they're simply overwhelmed by all their investment choices. While you can indeed choose from thousands of stocks and funds, there's plenty to be said for a very simple index fund or ETF approach.
Assuming your investment horizon is at least 10 years off, I recommend you put 90 percent of your money in a broad-based U.S. index fund or ETF and the remaining 10 percent or so in an international fund or ETF.
Sure, there are plenty of more complex strategies you could follow -- and I'm in no way suggesting they don't make sense -- but if you don't want to take the time or make the effort to actively manage your retirement account, my straightforward two-fund approach gives you great exposure to the global stock markets.
Index Fund or ETF?
If you want to go the fund route, the low-cost index funds run by Vanguard are a smart choice. Vanguard Extended Market Index fund (VEXMX) gives you exposure to both large cap and small cap companies, across a wide variety of industries. The Vanguard Total International Stock Index fund (VGTSX) gives you international exposure.
That said, Vanguard requires an initial $3,000 investment in the VGTSX funds, so given the typical $4,000 annual IRA max, you'll need to focus on the broad U.S. VEXMX fund first, and then add on the international fund in a future year.
The ETF version of the Extended Market Index is VXF, and for a broad-based international ETF there's the iShares MSCI EAFE index (EFA).
For those of you who prefer to invest in smaller monthly or quarterly chunks, the T. Rowe Price fund family allows periodic investments of just $50. It has a low-cost, U.S.-based extended market index fund (PEXMX), as well as an international index fund (PIEQX).