EXECUTIVE SUMMARY

* When individual clients receive an income tax refund, a bonus, an inheritance or another windfall or other extra cash, they have a number of options. The most prudent choices are investing, putting money in college savings or retirement accounts or paying off debts. By using the following step-by-step approach, CPAs can assist individual clients who are wage earners to make the most effective decisions on what to do with spare cash. Here are the steps:

* Invest in a 401 (k) or 403(b) retirement account up to the full extent of the employer's matching contributions.

* Pay off debts-beginning with those that have the highest after-tax interest rate.

* For higher education costs, invest in the client's state section 529 college savings plan up to the maximum amount eligible for state tax benefits.

* Invest up to the maximum in either a Roth IRA or a deductible IRA. Invest up to the maximum allowed in a 401 (k) or 403(b), For additional higher education costs, invest in any state's section 529 college savings plan and/or a Coverdell account.

* Pay off moderate interest rate debts in order based on the after-tax interest rate.

* For further retirement savings, consider an annuity. For those who prefer to have cash available, invest in tax-efficient mutual funds such as stock indexes and/or government bonds.

* Pay off lower interest rate debts in order based on the after-tax interest rate.

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When individual clients receive an income tax refund, a bonus, an inheritance or another windfall--or even have some extra cash on hand after paying off their bills--they have a number of options. The most prudent choices are investing, putting money in college savings or retirement accounts, or paying off debts. To help clients rate these alternatives, CPAs should consider three criteria: the after-tax rate of return, the risk and the effect on asset diversification.

While risk tolerance and asset diversification decisions vary for each client, tax considerations generally apply across the board. With that in mind, this article offers a step-by-step approach to the options based on their after-tax rate of return, providing choices that offer tax advantages no matter how much money is involved. For simplicity, the article assumes that the individual client is an employee and not self-employed.

STEP 1

MAKE THE MOST OF MATCHING CONTRIBUTIONS

When clients have any available cash, their first choice always should be to increase retirement account contributions to the maximum employer match. Contributions to 401 (k) or 403(b) retirement accounts that are fully matched by the employer yield an immediate return equal to the employer's matching percentage. Up to a set limit, matching percentages generally range from 25 cents to $1 on each dollar contributed by the employee--an instant 25% to 100% return on the investment. For example, if a company offers a 50% match on the first 6% of pay, an employee with a $50,000 salary should contribute $3,000 to the 401(k) to receive the maximum matching contribution of $1,500 ($50,000 x 6% x 50%) from the employer.

STEP 2

PAY OFF HIGH- AND MODERATE-INTEREST-RATE DEBTS

The next most effective strategy is to pay down high-interest-rate debts, particularly credit card balances. Pay off debts in order of their after-tax interest rates, beginning with the highest. Paying the balance on a credit card with a 12% annual interest rate is the same as receiving an annual after-tax rate of return of 12% on a risk-free investment. If the client itemizes deductions, paying down a loan with deductible interest provides a risk-free rate of return effectively equal to the loan's interest rate minus the marginal rate of tax savings forgone.

It's not necessarily the best policy to use up all spare cash paying off debts, however. Generally, at this stage clients should continue to carry debts with after-tax interest rates in the range of 6% to 8% or lower (this can vary depending on the current interest rate environment). Below this interest rate range, clients should be able to find more effective uses for their money than paying off debts, though more conservative clients may disagree. Still, even conservative clients should not pay off debts with an after-tax interest rate below about 6% before proceeding to step 3.

STEP 3

PARTICIPATE IN A COLLEGE SAVINGS PLAN IF IT PROVIDES STATE INCOME TAX SAVINGS

Clients facing future higher education costs next should investigate state-sponsored tax-advantaged college savings plans. (Those who do not receive state income tax savings for their plans or aren't facing these education costs should move on to step 4). In qualified plans covered by section 529 of the Internal Revenue Code, withdrawals generally are not subject to federal income tax if the money is used to pay for qualified educational expenses. If they are not, they are subject to federal taxes and a 10% penalty. If a child decides not to go to college, the funds generally can be used to pay for another family member. (For more on college planning, see "Financial Aid 101," JofA, Jul.05, page 79.)