Sink hefty tax refund into emergency fund?
Dear Dr. Don,
I just filed my taxes and will receive a $1,000 tax refund. I'm 26 with about $11,000 in a consolidated federal student loan, which is in repayment. I have not started a retirement fund, but I have $1,000 in an emergency fund.
I currently live with my parents, and my credit card debt is zero. I will be graduating this May, and I know that once I get a job, my income will at the very least double. Should I pay down my student loan, save it in a certificate of deposit, put the money in a high-interest savings account or open an individual retirement account?
I have no intention of going on a shopping spree with it, and I won't have much to add to the $1,000 from the tax refund, no matter where I put it.
-- Taras Target
I'm all about preserving financial flexibility. To that end, you don't want to put your money in an IRA or even pay down your student loan. You currently have $1,000 in cash reserves.
How many months' worth of living expenses does that represent? I'd argue that you want three to six months' of living expenses in that emergency fund, even when you're living at home, before you start thinking about investing or paying down your student loan.
I hear from too many readers who start repayment on their student loan only to hit a financial rough spot and have trouble keeping up with the payments. While there are forbearance options with federal student loans, keeping a cash reserve in a savings account or money market account with a bank preserves your ability to keep up with the payments during a period of unemployment. Use the $1,000 to pay down the loan, and you've lost that ability.
Once you get that job, it's a great idea to start saving for retirement in your 20s. It's too easy in the early years of your career to put off retirement savings, but the money you invest in your 20s toward retirement has 30 to 40 years to earn investment returns and grow in value. It'll make reaching your retirement goals that much easier.
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