Michael on January 23rd, 2009
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It’s Friday, so it’s time for this week’s reader-submitted Q & A. If you’d like to submit a question, click here for more information or simply email a question.

My wife and I are going to receive a hefty income tax refund.  We didn’t adjust our W-4’s properly until September ‘08 (after we read Beyond Paycheck to Paycheck), and by then we had already overpaid.

We have been saving aggressively but are still 4-months short of a 6-month emergency fund; I also have an unsubsidized student loan at 6.8% interest and a Roth IRA I haven’t funded in a long time. Meanwhile, Wall Street is having a huge sale.

My wife’s job is very secure, so I don’t believe the emergency fund is as crucial for us as for some people right now, after I get done grad school I am going to be a teacher in Philadelphia public schools district.

So, what do I do with my tax refund?

- Jeffrey R., Pennnsylvania

Short Answer: No one ever expects an emergency. If you did, it wouldn’t be an emergency.

Detailed explanation: Jeff, it’s great that you’re viewing your finances broadly.  Your long-term holistic view will be a key ingredient in your ultimate financial success.  Your question, while partly an investing question, is also one of financial priorities.  While you and your wife have strong job security as teachers, events other than sudden job loss cause financial emergencies. Such possibilities include car accidents, a health issues, and expensive unplanned home repairs.  While job security reduces one key concern, it does not eliminate all of them.

I, along with most financial planners, recommend a minimum of three months of living expenses for an emergency fund.  Those people who are self-employed are better served by having a year’s worth set aside. Most employed individuals can be comfortable with about three to six months.  Keep in mind that the number of months included in the emergency fund is necessary living expenses, not income. In a true financial emergency, you don’t spend money on discretionary items, so living expenses include only rent/mortgage, car payment, groceries, utilities, child-care, and other monthly payments you can’t change in the short-term.

Your sizable tax return may instantly give you the ability to get your emergency fund to an appropriate level.  If you’re left with additional funds, I’d consider saving for retirement, either by increasing your 403(b) contributions (tapping into your income tax refund to make up any cash-flow shortfall) and/or establishing a Roth IRA.

Since you’re decades from retirement, you have a long-term time horizon and the majority of your investments should be equities to take advantage of this fact. That “Wall Street is having a huge sale” is just gravy when you’re investing long-term. (If you would have asked is this a great time to buy given that you want to sell in five years for some other non-retirement goal, I would say “I have no idea.”)

Good luck, Jeff, and thanks for submitting your question!

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