What to do with a Windfall

It is tax season in the United States. That means that soon you may be receiving a tax refund from the state, or the federal government, or both. A tax refund is a financial windfall, or money that unexpectedly falls in your lap. Rather than spend it all on whatever you feel like buying today, let’s make a plan.

Most windfalls will be of a reasonable size, big enough to be exciting but not so big that we can quit our jobs. Maybe a few hundred or even a few thousand dollars. For these kinds of sums I suggest the following plan:

  1. 10% you spend on whatever you want. A nice dinner out, a new sweater, maybe a new computer if you got a really big windfall. That 10% is yours to splurge with, so enjoy!
  2. 45% you use to pay down debt. If you have any Credit Card Debt that might be a good debt to pay down first. If you are free of credit card debt, maybe you have student loans, a car loan, or a mortgage. If you owe anyone any money, use this part of the windfall to pay that debt down.
  3. 45% you put into your Emergency Fund. If you are still building your emergency fund you are that much closer to your goal amount.

Debt free? How is your emergency fund doing? If you are still working on having a good comfortably large emergency fund consider putting the full 90% in there. Fully funded emergency fund but not debt free yet? Use the full 90% to pay down debt.

Debt free with a fully funded emergency fund? Great job! For most people the right thing might be putting the windfall into retirement savings. In a future post I’ll talk about the trade-offs involved in saving for retirement, a house, a college education, and other long term savings goals. The short version of that post is: I think saving for retirement is the most important item on that list.

The important thing to keep in mind about windfalls is that they might feel big, but they’ll be spent in an instant if you don’t have a plan. So spend a bit on yourself, then dedicate the rest to becoming debt free, prepared for emergencies, and possibly saving for your long term financial goals.

Congratulations! You are one step closer to being in control of your money.

How Big Is Your Emergency Fund?

A few weeks ago I said that having an emergency fund was the most important first step in your money plan. Now I’m going to talk about how much money you might want to have saved in it.

Traditional thinking goes that you should have between 3 and 6 months of living expenses in an emergency fund. Perhaps 3 months if you are single with no children or other dependents, and 6 months if your income supports a whole family.

This rule of thumb isn’t bad, but let’s spend some time thinking about your own situation in detail. First, do you know how much money you spend every month? You do if you’ve been keeping a money diary for a year or more, or if you do annual financial checkins. Resist the urge to just add up what you think you spend, guessing at groceries, gas, mortgage and the rest. You’ll almost surely forget something, like the car insurance bill or holiday spending. If you don’t have a record of your monthly spending instead use your monthly income. If you spend less than you earn, and you should, then this number will be conservative but that’s what we like in an emergency fund.

Next, think about the number of people you support. Is it just yourself? You and a partner? Do you have kids or parents or others who depend on your income? Are any of them, like your spouse, also working or capable of working, or are they kids that can’t support themselves even a little bit? Maybe you help your mother with rent but her Social Security can cover her food and other expenses. Think about everyone you support in any way.

The more people you support, and the less they are capable of earning for themselves, the more money you’ll want in your emergency fund.

Finally, think about how secure your income is. Do you have a secure salaried job at stable company? Are you paid mostly by commission? Are you a contractor or temp? Are you self employed? The less certain your income the more money you’ll want in your emergency fund.

3 months of living expenses (or 3 months of salary) is a good goal if you are single with no dependents and have a secure job. If you have a spouse and a few children, and a secure job, then 6 months of living expenses (or 6 months of salary) is a good goal. 9 months or more might be realistic if you are supporting extended family plus your own spouse and kids, and you work on commission.

The more people you support and the less secure you income, then the more you want to save.

Having 9 or 12 months of living expenses or salary sitting in a savings account or CDs might feel like a waste. But the piece of mind that a well funded emergency fund provides is undeniable. It is the solid foundation upon which you build the rest of your money plan. Don’t neglect it or make it too small. Fund it well and may you never need to use it.

Congratulations! You are one step closer to being in control of your money.

Free Tax Return Preparation for You by Volunteers

No doubt about it, taxes can be stressful. Will you owe money or get a refund? What special tax programs are you eligible for? Will you be able to read those long IRS instructions without falling asleep? Lots of people aren’t comfortable filling out their tax returns, even with the help of a step by step tax program.

Good news, there is free help available. If you earn $50,000 a year or less, or you are at least 60 years old, you may be eligible to have your taxes prepared for you for free. Every year the United States IRS trains and tests thousands of volunteers to do free tax preparation. The programs, Volunteer Income Tax Assistance (VITA) and Tax Counseling for the Elderly (TCE), are run by the IRS but coordinated through local organizations and charities. You don’t even need to be a US citizen, you just need a social security number or an ITIN.

I volunteered for VITA last year and will volunteer again this year. I can attest to the fact that the training is thorough and the tests are hard. These volunteers know their stuff, have access to each other and their well trained coordinators, and have an IRS helpline they can call at any time with tough questions. They understand taxes, and they want to help you.

If you have any doubts about filling out your own taxes and are eligible for these programs, don’t hesitate to give it a try.

Get more information at the IRS website.

Money Diary

Budgets. They are the cornerstone of good financial planning, right? I don’t think so. I think that creating a budget with everything you might spend money on is impossible, frustrating, and ultimately a bit backwards. Instead, I think everyone should have a money diary.

A money diary is the opposite of a budget. Instead of planning what you will spend money on, in your money diary you keep a record what you actually spend. People make budgets to make sure they don’t spend more than they earn, and to make sure they’ll have enough money to meet all their financial goals, like taking a vacation next year or retiring someday. For most people I think that keeping a money diary is a much better way to do those things.

Here is how a money diary works. Get a paper notebook, a spreadsheet on the computer, whatever works for you. In your diary record all the money you spend. Record as much or as little information as you want, but record every penny that you spend. Then every once in a while, like once a month, review the diary and you’ll see exactly what you are spending your money on. With a budget you might forget to include some things, like the car oil changes or a present for your nephew on his birthday. Those sorts of expenses will never be missed by a money diary!

A simple money diary might record that you spent $50 at the grocery store, withdrew $40 from the ATM (but not how that cash was spent), paid $36 to the utility company, etc. You might think this looks too simple to be useful, but the process needs to be very easy so that you’ll stick with it. If you’ve never kept a record like this before don’t be tempted to make a big complicated diary right away. Keep it simple and let it grow in detail only when it will be useful. If at any point you are finding the diary too much work to do, ask yourself how you could make it easier and simpler then do that.

Reviewing your money diary can happen as often as you want, but I don’t recommend doing it less than once a month. Sit down and just read all of the entries since your last review. Total up how much you spent, is it more or less than you were expecting? Did you spend more this month than last month, or less?

You might be surprised at how much money you are spending on certain things, for example at the grocery store. So you can start recording how the grocery bills split between different things like food and toiletries. The next time you review you’ll see why those grocery bills are so high, and then you can take action. Buying too many avocados out of season? One too many steak nights last month? Whatever it is that is inflating your bill can be put to the test: is eating steak every week worth more to you than your other goals, like getting out of debt?

Your money diary is a tool, and it is yours to grow and adapt to your needs. You might someday record how you spent the cash from the ATM. You might consider giving things categories, which might be as simple as “needs” and “wants” or as complex as “fruit,” “electricity,” “tips,” etc. But only do these things if they will help you understand where your money goes. Never do it just because it seems like a good idea; you’ll make the money diary so much work that you’ll be tempted to delay filling it out then give up.

For some people the very easiest way to start will be to save all of your receipts. When the pile of receipts gets big, or when you want to do a diary review, you can turn the receipts into entries in your diary.

I will be making a template printable money diary for everyone who loves paper, and a spreadsheet for everyone who loves computers. In the meantime, start with whatever you have and start your money diary today! Don’t force yourself to use a spreadsheet even though you don’t like them just because it seems “more right” than a paper notebook. Paper is great, and anything you’ll find pleasant to use and maintain is best of all.

Congratulations! You are one step closer to being in control of your money.

Credit Card Debt

In my opinion the second step to gaining control over your money, after the creation of an emergency fund, is the elimination of your credit card debt. If you don’t pay your credit card bill in full every month you are making bankers richer and yourself poorer, simple as that.

Being debt free should be your goal. If you are ready to start tackling your debt, and you have credit card debt, student loans, and a mortgage, you might wonder which you should pay off first. One way to decide is to pay off the debt with the highest interest rate, which is almost always going to be your credit card debt.

When you don’t pay off your credit card every month you are ‘carrying a balance’ on that card. Credit cards charge you interest when you don’t pay off your card completely every month. Basically you are paying the bank for the privilege of borrowing money, exactly the same as you do if you have a mortgage. But when you get a mortgage and pay that interest you have a roof over your head in return, so paying interest might feel like a pretty good trade off. On the other hand, if you bought a new television with your credit card and weren’t able to pay off the credit card bill that resulted, you are paying a little bit more every single month for that television.

According to bankrate.com the average interest rate on so-called ‘low interest cards’ is currently 10.96%. That means that if you are carrying a balance of $1000 you will pay the bank $109.60 in interest every year, or $9.13 a month. Doesn’t sound like much, but that is $9 that could have bought you lunch and is instead buying a bank executive lunch.

The first step to paying off credit card debt is to stop increasing the balance. In other words stop using your credit cards: staunch the bleeding, if you will. Now, for some people that will be easier than for others. For many people this won’t be possible without starting a budget, something I’ll talk about in a future post. Some people might find it impossible to stop using their cards all together, especially at first. Try picking just one card, preferably the one with the lowest interest rate, to keep using and stop using the rest.

The next step is to pay off the credit card with the highest interest rate. This will save you the most money right away. Pay as much as you can each month; even paying $10 more than the minimum payment is worth doing. The lower your balance the less interest you are paying the bank.

Once the first credit card is paid off start paying off the credit card with the second highest interest rate. Because the first card is paid off you can use all the money you were devoting to the first card every month and devote it to paying this bill. In this way, slowly but surely, bit by bit, your credit card debt will be eliminated.

Finally, if you find yourself wanting some individual expert advice, I recommend you talk to a credit counselor. The Federal Trade Commission has an informative page about how to choose a credit counselor. A reputable credit counselor can really help you get back on track.

Congratulations! You are one step closer to being in control of your money.

Emergency Fund

In my opinion the most important first step to gaining control over your money is the creation of an emergency fund. You may be living paycheck to paycheck, or you may have more money than you know what to do with: in either case you need an emergency fund. A small stash of money that is dedicated to covering emergency expenses, a stash that may start small but grows over time, is a cornerstone to your money plan. Your emergency fund gives you peace of mind and some financial security.

Unexpected expenses, big and small, happen to all of us. You own a home and have a plumbing emergency. One of your car’s tires is irrepairably punctured and must be replaced. You sprain your ankle and, surprise, the emergency room co-payment is $200. When you have an emergency fund these events become a bit less stressful. You still have to call the plumber, go to the tire shop, live with a sprained ankle. But now you don’t have to wonder how the cost of it all will affect your cash flow. Without an emergency fund you might worry about what other bill won’t be paid this month, or if there is enough money in your checking account to cover the automatic retirement contributions. Thanks to the emergency fund you can focus on the event instead of your balance sheet.

Your emergency fund should be a dedicated bank or credit union account. The most versitile option is a checking account so you can pay bills directly from it without transferring money around between accounts. You might be tempted to mentally set aside a portion of your checking or savings account as your emergency fund. Please resist this temptation! It is all too easy to forget this mental bookkeeping and spend your emergency fund on other things, leaving you vulnerable.

Your emergency fund might start out very small, just a few dollars, if that is what you have right now. The sky’s the limit on how much money you could save there. The larger the fund the larger the emergency you can absorb. Try not to worry too much yet about how much money should be in your emergency fund. We’ll cover that in a future post. The most important thing is to start. So now, ask yourself how much money you can comfortably set aside into it right now. Then open a new checking account and deposit that amount.

Congratulations! You are one step closer to being in control of your money.

Teaching Children About Money

Money As You Grow

Teaching children about money is tough. When they are very young a child’s ability to understand an abstract concept like money is pretty limited. As they get older it might feel easier to just give them an allowance and skip the more weighty ideas of setting a budget and planning for the future. By the time they are turning 18 you may be hesitant to have in-depth discussions and risk admitting the limits of your own financial knowledge and planning.

The President’s Advisory Council On Financial Capability has your back. They’ve made an easy to use website called Money As You Grow which is all about the financial lessons kids should learn at different ages. 3 year olds learn that you need money to buy things, while 11 year olds are learning about the power of compound interest. Each lesson has several activities, like giving the child a few dollars and letting them choose which fruit to buy at the store to demonstrate that you need to make choices about how to spend money.

In their own words: “Families can use Money as You Grow to start a dialogue about money and teach kids important lessons about saving, making choices, and avoiding debt. Put up a Money as You Grow poster on your refrigerator, try the activities in your everyday life, and check to see if your children know the milestones for their age groups.”

Money As You Grow has a slick website, several free posters to print, and easy to understand activities to do with the kids in your life. And I won’t tell if you learn a new thing or two yourself while you’re at it.