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Where to Invest Your Tax Refund Check

Jason Stipp
Christine Benz

Jason Stipp: I'm Jason Stipp for Morningstar.

Tax season is finally over, and if you're among those lucky enough to get a tax refund, you may be wondering what to do with that small "windfall." Morningstar's Christine Benz, our director of personal finance, has a few ideas to use that tax refund smartly. Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: One of the first things that you will want to do when you get that refund is,  look at the size of it. The size of that refund may be telling you something?

Benz: It may be. It may be telling you that you are withholding too much, and giving the IRS an interest-free loan. So, if you are getting a very large check back, really take a look at your withholding and think about adjusting that so that you aren't withholding so much and that you won't receive such a big refund next year, but you also won't be giving the government that loan all year long.

Stipp: So hopefully you'll get a little something back instead of owing, even if you've kind of optimized that withholding. There are a few different ways that you might think about using this money. You might not want just go out and splurge and spend it.

If you want to put it to work, you have a set of priorities on what you might consider first, second, third, and fourth. What's priority number one? Where should you put that money to work first?

Benz: Well, I think you want to think like a business owner, a business operator, and think about what is the best bang for my buck given how much I have to invest.

So, certainly for folks with high-interest credit card debts, where you're not getting any tax benefit in having that debt, the interest rate is high, you'd want to put any proceeds from your tax refund toward that, because that is going to give you the highest-return payoff on your money. So that would be step one.

Stipp: So, say, I've got my debts under control, what's step two? What would I do if I have some of that refund money left over?

Benz: The other key thing I would focus on is making sure that you have an emergency fund that is appropriately funded. We usually think of that as being three to six months worth of living expenses, and it doesn't have to be three to six months of what you're spending now, but three to six months of what you could get by with in a pinch. And the high-return payoff of that is that if you did have to tap your credit card or some other source of funding [in an emergency], you could end up costing yourself a lot of money. So, you are better to create that emergency fund, make sure that you have money stashed away in true cash to pay for any emergency car repairs or home repairs or unanticipated expenses of any kind--a job loss, certainly.

Stipp: So, I've got my debts taken care of. I got my emergency fund build. Now I want to put some of that refund to work in the market. What kind of account should I consider first?

Benz: I think you want to focus on those accounts that do bring you some tax benefits by investing there. So, it really depends on what your priorities are in terms of your goals, but two key account types I would consider would be either a Roth IRA for people who are investing for retirement, or perhaps a 529 plan if you're investing on behalf of a child or a grandchild.

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Stipp: Now with those IRAs, I know there are certain rules about how much you can make to contribute to them, and also that you need to have earned income to contribute to them. Is it OK to use a tax refund in that case to fund one of these accounts?

Benz: It is, Jason, as long as you do have earned income that's large enough to cover the amount that you are investing. So you don't actually have to be investing the same earned income dollars in the IRA. It doesn't matter where you get the money, it just matters that you had enough earned income in the year in which you are funding the IRA to cover that IRA investment.

Stipp: So Christine in an IRA you have lots and lots of different [investment] choices typically. I just want to get some of your ideas on a fund that you might want to consider. There are a few different investor types that we typically have on Morningstar.com. We tend to have a good group of more conservative folks--folks who are getting closer to retirement. Do you have a fund idea that they might want to take a look at, as one of the options where they could put that money to work?

Benz: I do, Jason, and a key first step, I think, before making that investment is seeing where you have holes in your portfolio, or where you need to maybe top-up your allocations versus your targets.

So, assuming that you have done that exercise and you realized that you're too short on conservative investments, one good all-purpose fund that I often recommend, especially to younger folks who are looking at their portfolios and saying, "I need some bonds, but I don't know where to begin," is T. Rowe Price Spectrum Income, and the reason I like it is that it's a very well diversified fund. It holds lots of different bond funds--corporate, government, mortgage-backed bonds. It also holds a small slice of equity exposure in T. Rowe Price Equity Income, and so it's a well-diversified package. It has historically been pretty low-risk relative to other funds in its category, which is Multisector Bond. I just think of it as a great one-stop shop for people who determine that they need more income-type exposure.

Stipp: What about for that more aggressive piece of your portfolio, Christine. Any ideas? Maybe something that might look globally, for example?

Benz: There are a lot, and I do think a global fund is a really interesting idea. One that our analysts particularly like is Dodge & Cox Global Stock. This is a firm that has done a solid job on its domestic equity funds, also a good job on its international stock fund. This particular product marries the two skill sets. It's a fund that came out at an inopportune time in 2008. Performance has been a little bit volatile. But we think that the firm is topnotch and that their research capabilities are topnotch, and like all Dodge & Cox funds it's very, very cheap. So I think it's a just a great core, more aggressive option for someone who needs equity exposure.

Stipp: You mentioned earlier, Christine, that a 529 plan could be another place you could put some of that tax refund money to work.

This is an area that can often be pretty confusing--lots and lots of choices. Morningstar has done some research on 529 plans. We see a few places that we think could serve investors well, right?

Benz: We do, and so I think your first bit of homework if you decide you want to fund a 529 is just see what kind of tax breaks your home state will offer for you making contributions to your home state's plan. So start there. If that plan is lousy, then maybe you want to move on and look at what Morningstar has rated its best plans.

Two that I particularly like are the Vanguard managed plan from Nevada and Utah. They are index-based lineups, very, very inexpensive, and have a good array of investment options under the hood. So, I think that those are great options for people who don't like their home state plan or happen to live in one of those two states.

Stipp: Let's say that I have some money left over. Maybe it's part refund money, maybe it's some other money that I want to put to work after I kind of look through these priorities. What would I do next? What would I do with that money now?

Benz: Well, I think it's kind of a tie. If you have a mortgage or some other source of low-interest debt that also carries a tax break, you might consider allocating some assets to paying down that mortgage maybe a little more aggressively than your payment plan calls for. So that's one idea.

Another idea is to simply fund a taxable account, and there I think you want to take care to select good tax-efficient options. So, ETFs--exchange-traded funds--as long as they are tracking broad market segments, can make a lot of sense. Traditional index funds, same idea: good tax-efficient structure there, particularly if you're focusing on a broad market segment.

Or I still like the category of tax-managed funds, particularly given all the tax uncertainty that we're facing. The nice thing is, tax-managed funds can address the tax changes as the years go by. They can change their strategies. So if dividend tax rates pop back up, they could decide to suppress dividend payers. So I think that that ultimately may be the most tax-efficient category of all.

Stipp: Christine, a very detailed and excellent action plan for those who will be seeing a check from the government in the next few weeks. Thanks for joining me.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.