Think Foolishly With Your Tax Refund

So this year you decided -- as 75 million taxpayers did last year -- to electronically file your federal income taxes. If you used an online service, like TurboTax by Intuit (Nasdaq: INTU  ) or H&R Block's (NYSE: HRB  ) TaxCut, and you're due a refund, what will you do with your "gift" from Uncle Sam?

Since refunds can be quite a chunk of change, you would be wise to think Foolishly about how best to use that money. For example, in 2003, taxpayers received a check for $2,113, on average. (For more on how to avoid giving Uncle Sam an interest-free loan, click here.)

Sure, using the cash to take a trip around the world would be nice, but suppose the refund check isn't quite that large. Resist the temptation to spend it away. Yes, I know that big-screen TV at Best Buy is tempting. So is that Apple iPod, not to mention Canon's new 8 megapixel digital cameras. But instead, consider a few suggestions on how to use your refund Foolishly.

1. Pay off your credit card debt
Here's a trivia question: What is the second step to Foolish investing? If you answered paying down all credit card debt, you are correct! Your money may be getting sucked into a compound-interest sinkhole if you're not paying off your credit cards every month, especially with interest rates on many cards at 18% or higher.

But suppose your refund isn't enough to pay off your credit card debt completely. Here's an example of how adding a few extra dollars to your monthly payments can help you save money.

Let's say you owe a balance of $1,000 on your SkyHigh credit card account. The interest rate is 18%, and the minimum monthly payment is $25.

By sending only the minimum each month, you wouldn't pay off the balance for five years, and the interest over that period would rack up to over $500. Adding $10 to that minimum payment -- for a total of $35, in this case -- you would be out of debt two years sooner and would save roughly $200 in interest.

2. Invest in stocks
Consider starting an investment account, or add the money to an existing account. A Foolish investor knows that even a small amount, properly invested, can grow to a nice nest egg through the power of compounding.

Say you take a refund check of $1,000 and put it into the stock market. Calculating a return of 11% a year (the S&P 500's historical average), that grand would double to $2,000 in about six and a half years. At a 15% return, you would double your investment in only five years.

3. Get into Drips
You Fools who have limited funds for investing or want to start off small, don't fret. A good way to start investing is with dividend reinvestment plans, or Drips. What exactly is that, you ask?

Many dividend-paying companies offer Drips, which allow you to reinvest your dividends into additional shares of stock. These plans offer a way to begin investing with a very small amount of money, and they let you keep investing as frequently as you can afford. Since Drips are a form of dollar cost averaging, you can accumulate additional shares over time by investing a certain dollar amount regularly through up and down periods. That way, you'll buy fewer shares of stock when prices are soaring and more when stock prices are trading lower. In the long term, it's a great and steady way to grow your money. That's very Foolish.

But keep in mind that just because a company pays a dividend or offers a reinvestment plan, that doesn't automatically equate to the stock's being a good investment. Fools know to do their homework before committing money to any plan. Always understand the company's business, and determine whether the stock suits your risk tolerance.

For frugal Fools, drug retailers CVS and Walgreen have minimum investment requirements of $100 or less. For those who can invest $250 or more, choices include blue chips like Wal-Mart, General Electric, Home Depot, and Yahoo!, just to name a few. For more about how to invest in Drips, check out "How a Fool Can Invest in Drips" by Jeff Fischer.

4. Diversify with index funds
Longtime Fools will wonder why I would suggest mutual funds. After all, to be a Fool is to learn how to be your own money manager and not rely on a Wall Street "pro." However, this type of investment can be a part -- notice I said a part -- of your overall investment portfolio.

Folks choose mutual funds because they are convenient, cost-effective, and a lot less risky than individual stocks. Plus you get instant diversity. The key to success is in knowing what you are buying, and picking your funds carefully to achieve proper diversification in your current portfolio. If you've not yet started, a good place to begin is an S&P 500 index fund.

But watch out for sale loads and fees. You don't get superior fund performance by paying excessive management fees. And don't put a lot of faith in the headlines touting a fund beating the S&P index over the past year. That's fine and dandy, but what about the performance over the past three, five, and 10 years? The truth of the matter is that over time, the vast majority -- some 80% -- of mutual funds underperform the S&P 500's average return.

For the most part, picking a fund is just like investing in individual stocks. Low-cost funds such as the Vanguard 500 Index Fund (FUND: VFINX  ) or the Fidelity Spartan Total Market Index Fund (FUND: FSTMX  ) , are good choices because they are no-load. You don't pay an upfront sales charge just to own a fund.

Another investment idea to consider is exchange-traded funds (ETFs). These funds trade just like stocks and offer an accordingly higher degree of flexibility. Examples include Diamonds (AMEX: DIA  ) , Spiders (AMEX: SPY  ) , and Cubes (Nasdaq: QQQQ  ) . These ETFs track the Dow Jones Industrial Average, S&P 500, and Nasdaq 100, respectively. The caveat here is that these types of funds do carry trading commissions, where funds do not. But management fees on ETFs are most often lower than on funds, and that's a factor worth considering. Read and understand the prospectus before committing your money to any mutual fund.

5. Contribute to your retirement
What better way to plan for the future than to save for tomorrow? Taking the refund check to start an IRA is akin to planting a seed for a later harvest. If you are self-employed or work for someone else and receive earned income, then you are eligible to make a contribution. There are more choices today than ever before. Don't know which IRA is best for you? Check out the Foolish IRA Center for all the details.

Fool contributorKelvin Taylordoes not own shares of any of the companies mentioned in this article. Interested in dividend-paying stocks? Like the convenience of funds? Consider a subscription toMotley Fool Income InvestororMotley Fool Champion Funds. You'll be glad you did.The Motley Fool is investors writing for investors.


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