Putting Your Income Tax Refund to Work

The weather may be odd this May, but it is still the leading month for tax refunds, and many people are watching their mailboxes with eagerness.

Two out of every three Americans will qualify for a tax refund in 1998. The average rebate on federal returns: about $1,350. Californians average another $400 on state returns.

I won’t spoil the party by harping on the fact that refunds are best avoided, because they represent tax-free loans to the government. Instead, let’s focus on ways to put a refund to work in the stock market. Although $1,350 isn’t a bonanza, it’s enough to get started with an investment program if you haven’t yet done so.

Many Americans are receptive to the idea of investing their tax refunds, rather than blowing the wad on big-screen TVs, exotic pets or other luxuries. About a third of the respondents in a recent poll by Alliance Capital Management of New York said they intended to invest their tax windfalls. Another third planned to pay off debts. Only a small fraction had their cross hairs trained on big-ticket expenditures.

“Tax refunds can be a good starting point for an investment program, since you’ve got the opening deposit,” said Margie Mullen, a certified financial planner at Mullen Advisory in Los Angeles. Even $1,350 is enough to get going with dozens of good mutual funds. And you can build on that by investing refunds received in future years.

Why mutual funds? Because they provide more diversification bang for the buck than you could afford with a handful of individual stocks or bonds. Each mutual fund invests in dozens of stocks or bonds--an arrangement that lessens risk in case a few holdings blow up. Also, it would be hard to afford more than a handful of individual stocks for $1,350 unless you bought only a few shares of each--an uneconomical option due to commissions.

So which types of mutual funds are best, assuming you are just getting started?

First, narrow the choices by weeding out inappropriate picks. Forget about sector plays because they’re too concentrated in a particular industry. Ditto for pure international funds, because they lack exposure to the U.S. market. Likewise, pure bond funds are too conservative unless you’re retired.

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What’s left is a range of broad-based funds that invest mainly in American companies.

To whittle the choices further, you must figure out what you’re trying to accomplish with the money. Suppose you’re in your 20s or 30s and can afford to hang on to a fund for at least five years. Next, imagine that you have some cash on the side, perhaps in a bank account, which you could tap in an emergency without dipping into your investment portfolio. Advisors recommend enough cash in reserve to meet living expenses for at least three months.

And let’s assume that you have adequate protection in terms of life insurance and, especially, disability coverage.

Finally, let’s assume you don’t have high-interest consumer or credit card debt. (If you do, use the refund to pay it off.)

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If you’re fairly young, injury presents a greater risk than death and should be your prime concern, says Pat Raskob of Raskob Kambourian Financial Advisors in Tucson.

To choose one fund with your tax-refund check, given the above circumstances, Raskob recommends Scudder Small Company Value ([800] 225-2470).

It’s only 2 1/2 years old, but it has blown the lights out so far, as seen by a 45% surge over the 12 months ended May 7. Any fund that rises so fast can fall just as quickly, of course, so expect some bumps along the way. But if the stock market continues to advance over the next decade, as Raskob expects, this small-company pick could deliver some nice results.

As an alternative, Raskob also suggests American Century Income & Growth ([800] 345-2021). It’s hard to argue with this selection, which unlike the Scudder fund targets some of the largest companies. American Century Income & Growth has outdistanced Standard & Poor’s 500-stock index since its inception in 1990--a rare feat. It was up 40% over the 12 months ended May 7. And it has managed to beat the market while subjecting shareholders to slightly less risk.

Mullen suggests a different tack for her version of a tax-refund portfolio. Her pick: Janus Worldwide ([800] 525-8983). This is a global fund that holds a mix of U.S. and foreign stocks, usually favoring the former. It’s a good choice if you think American companies are due for a breather. “With Janus Worldwide, you don’t have to split your cash among two separate funds,” she said.

Helen Young Hayes is the manager of Janus Worldwide, and her results have been excellent. Still, one can’t help but notice the fund’s expanding waistline--at $14 billion in assets, it’s among the largest global portfolios anywhere. I think it’s significant that last month Janus shut the doors of Janus Overseas, a sibling foreign stock fund that counts just $4 billion in assets. It too is run by Hayes.

The normal minimum for all three funds is $2,500. However, Scudder, American Century and Janus will lower their requirements if you set up an automatic investment program. To do this, you sign an application allowing the fund company to pull a fixed amount of cash from your bank account each month. American Century and Janus will let you get started with as little as $50 a month. Scudder requires a $1,000 minimum and a $100 commitment each month thereafter.

So there you have it: three funds, each an eye-catcher. And to this mix, I’ll add my own tax-refund pick: T. Rowe Price Spectrum Growth ([800] 638-5660). Its performance hasn’t been quite as hot, but I would expect it to hold its ground better amid turbulence.

Spectrum Growth is more than one fund--it’s really nine separate portfolios. It invests not in individual stocks but in other T. Rowe Price funds. Thus shareholders gain a stake not solely in large or small or foreign stocks, but in all three. Spectrum Growth posted a 26.4% gain over the year ended May 7, and although that is behind Janus Worldwide (up 31.5%) and American Century Income & Growth (up 40%), it is closer to those if you consider longer periods. Yet its volatility or riskiness has been lower.

T. Rowe Price usually requires a $2,500 minimum for taxable accounts, but it will open the door to investors who commit $50 or more each month.

As with any asset-allocation fund, Spectrum Growth’s sum is only as good as its parts. But fortunately, the parts are pretty good. Researcher Morningstar Inc. of Chicago ranked T. Rowe Price as the top stock-fund family in 1997, for the second year in a row. Spectrum Growth isn’t as flashy as some of its competitors. But if you think the market could suffer a few down quarters in the years ahead, consider sacrificing some sparkle for what is more likely to be an overall smoother ride.

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Russ Wiles is a mutual fund columnist for The Times and co-author of “How Mutual Funds Work.” He can be reached at russ.wiles@pni.com.