31 Jan Should I use my tax refund to pay debt or invest?

Q. I expect to get a larger than usual tax refund. I’m trying to decide if I should use it to pay off some debt – a HELOC and a credit card – or invest it in an IRA. What should I consider?
— Can’t decide

A. You have a lot to consider, and we’re glad you’re planning to use the refund in a way that will improve your financial situation.

This refund is an opportunity to think about your total financial picture, said Frani Feit, a certified financial planner with Tradition Capital Management in Summit.

In looking at each option, she said, you should consider interest rates and taxes.

“Typically, advisors suggest paying down credit card debt first as the interest rates are usually very high,” she said. “If you have a credit card which carries a 23 percent annual percentage rate and you are earning 6 percent on your investments, you will be 17 percent ‘short’ in payout versus earnings and credit card debt is not deductible interest.”

One workaround is to transfer the high interest debt to a lower or zero percent credit card, she said.

Feit said the interest on the home equity line of credit (HELOC) is deductible as long as the proceeds are being used for actual home improvement related expenses.

“A HELOC used to fund a vacation or pay student loans is not deductible interest,” she said. “And while most HELOCs carry a variable – floating – rate, these rates are substantially lower than most major credit card rates.”

Next let’s look at investing in a traditional IRA, which not only provides future funds for retirement, but a tax benefit as well.

Feit said your IRA contribution reduces your taxable income: If you earn $75,000 and contribute $5,000 to a traditional IRA, you will be taxed on only $70,000 of income.

“There are certain income limitations that may prohibit you from investing in an IRA if you are covered by a plan at work so it is important to review those rules,” she said.

For the 2018 tax year, you have until April 15, 2019 to open and fund an IRA. The IRA contribution limit is $5,500 plus an extra $1,000 if you are age 50 or over. For tax year 2019, the IRA contribution limit rises to $6,000 plus the $1,000 age 50 and over “catch up” contribution, Feit said.

Another option with your refund – and one which creates the most valuable type of account – is the Roth IRA, Feit said.

She said Roth IRAs carry the same contribution limits as traditional IRAs but they do not provide a tax benefit up front.

“These IRAs are funded with after tax money so the true benefit of a Roth is that after five years, the earnings can be withdrawn tax-free – the contributions can be withdrawn with no tax effect at any time,” she said.

But of course there’s a caveat. Roth contributions are subject to income limitations.

For 2018, the adjusted gross income (AGI) range is $189,000 to $199,000 for married couples filing jointly and for singles and heads of household, the income phase-out range is $120,000 to $135,000, Feit said. If you earn over the top range limit you are prohibited from making a Roth contribution.

So back to the refund…

“If your credit card debt is getting out of hand, take the refund and pay off the highest percentage card first,” Feit said. “Then if there is money left over and your income falls either within or under the AGI range, invest in a Roth IRA.”

Feit said it’s important to find balance in our financial lives. Paying down debt to live comfortably now while investing for the future are goals that can both be achieved over time.

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