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Whenever tax seasons rolls around there are a lot of people who are chomping at the bit to get their hands on their tax refund. And for good reason. The average tax refund in recent years has been hovering around $3,000, and that’s just for federal taxes. Obviously, a $3,000 windfall could mean a lot in a shaky economy. It could be the difference between making a mortgage payment on time or not. But what if your finances aren’t that tight and you’re going to be receiving a sizable tax refund this year? What should you spend the refund on?
You have many options. You can pay bills, pay off debt, save it, spend it, or invest it. As you can see, that means there’s probably no single right answer for everyone as your financial situation will largely dictate what makes the most sense. That being said, there are a few ways to prioritize how the tax refund gets spent so it’s put to good use. Want to know how much money to expect back this year? Try out the tax refund estimator.
The Tax Refund and Free Government Loan
I’m sure you’ve heard it before, but many financial gurus hammer home the idea that you shouldn’t be happy about getting a large tax refund because it simply means you’re giving the government a free loan with your money. Now on the surface, that’s true. A tax refund is simply the government giving you back the excess money you paid in taxes. It isn’t some government windfall or actual free money. So in a sense, yes, you did give the IRS money to use for free for most of the year before they give it all back (with no interest for the privilege). But is that such a bad thing?
If you are meticulous with your money and strive to keep your tax refund close to zero and then go on to calculate how much extra money you have with each paycheck and put it to use every month, then yes, there are better options for your money. The reality is that most people can’t or won’t do this. Even if they adjust their tax withholding so that their big tax refund approaches zero, the extra few hundred bucks a month typically never gets saved, put into a retirement account, or applied toward debt. Instead, it gets whittled away each month without really impacting any major financial goal.
In situations like this it’s better to be forced to save, even at zero interest, than it is to have a little extra money in each paycheck and spending it without even realizing where it’s going. If the tax refund has anything going for it, it’s that many people who otherwise can’t be disciplined enough to actively save, invest, or pay extra on debt each month, are forced to save and once a year receive the fruits of that labor in the form of a refund.
Obviously, if you have the discipline to do so, you are better off calculating the correct tax withholding on your W-4 and trying to get your tax refund close to zero. This will put extra money into your pocket with every paycheck and that means you can control how it is used rather than letting the government hold onto it for you where it’s not being put to work. But for everyone else who can’t, or isn’t sure they can pull this off, there are still some good uses for that tax refund.
Avoid a Refund Anticipation Loan
If you’re expecting a refund this year, there’s one thing you must certainly avoid: tax refund anticipation loans. You’ve seen the commercials where tax places, or even auto dealerships or your bank, claim to be able to give you your tax refund even before the IRS has a chance to process your return and mail out the check. Resist this urge at all costs. Yes, getting your hands on your own money as soon as possible sounds like a great opportunity, but this is a wolf in sheep’s clothing.
For the privilege of getting your refund a few weeks early, you get hit with stiff fees that will take a bite out of the amount you receive. How stiff are the fees? Well, they are akin to payday loans. It depends greatly on who is offering the RAL, but it often works out to an APR anywhere from 50-500 percent. Would you really be willing to pay that much just to borrow your own money for a few weeks? Well, if you take out an anticipation loan, you basically are. And there is more bad news. If the IRS denies your refund, finds errors, or otherwise reduces the amount you were expecting to get, guess what? You’re on the hook for repaying the loan. The bottom line is that you should avoid these at all costs. Since we’ve covered how not to receive your refund, let’s talk a little bit about good ideas for spending it.
How to Spend Your Tax Refund
The first, and probably most obvious choice is to spend your refund on paying down high-interest debt. If you are carrying high-interest credit card debt, then applying a large payment to reduce the balance will provide both an immediate impact, but also a long-term impact by reducing interest charges by the tune of thousands of dollars over the course of a few years. Just how much could this save you? Well, let’s look at a quick example.
Say you have a credit card with a $10,000 balance and a 19.9% interest rate. For this we will also assume the minimum monthly payment is $200 a month. If you were to continue to just make the $200 payment on this card, it would take nearly nine years to pay off the debt. While that is a long time, even more shocking is the amount you would pay in interest during that time. You would have paid almost $11,000 just in interest on that original $10,000 balance! Now, what happens if you decide to take your $3,000 tax refund and apply it directly to this debt? The numbers are astonishing. Just by putting $3,000 on that credit card, even if you wanted to continue making the same $200 monthly payment, you would cut the repayment period down from almost nine years to just a little over four years. That shaves almost 4.5 years off! Even better, your total interest paid on this credit card drops to just $3,300. That is a savings of more than $7,000!
If that doesn’t open your eyes, I’m not sure what will. You can essentially take what feels like free money from the government and apply it toward high-interest credit card debt and put thousands of dollars into your pocket and shave years off of your goal to become debt-free. If you are carrying credit card debt this is no doubt the single best use of a tax refund. Is it as fun as buying a new TV or going on a little vacation? Of course not, but over the long run it will turn out to be one of the best financial decisions you could have made.
If you aren’t carrying high-interest debt the next option to look at would be saving it if you don’t already have adequate savings. An emergency fund is a must, and if you don’t have enough money set aside to pay the bills for at least three months in the event of a job loss or other financial emergency, then you’re setting yourself up for trouble if something does happen. If this describes you, then putting that tax refund into a savings account is a good bet. If you already have a savings account you can build on that, but if you don’t have a dedicated emergency savings account set up you might as well open a high-interest online savings account and get started. The interest on a savings account won’t make you rich, but that isn’t the goal with this money. You simply need it to be liquid so that in the event of an emergency, it’s there for you.
An emergency savings is a good start, but if you’ve already got that covered you may want to think about other big-ticket items you’re saving for. This might include a vacation, a new car, or even a down payment on a house. Whatever your savings goal is, using a tax refund to give it a good boost will help keep you on track to reach that goal.
After your savings goals have been taken care of it’s time to look at your investing situation. Have you maxed out your 401k or IRA? If not, this is a good opportunity to juice up your retirement nest egg. I know a few thousand dollars doesn’t seem like much in the grand scheme of retirement, but trust me, a little bit today goes a long way. I’ll put it this way: if you were to take a $3,000 tax refund today and put it into a retirement account and earned just a modest 6 percent a year on average, in 30 years that would grow to over $17,000. Nice, right? Well, here is where things really get interesting. If you took your $3,000 tax return and put it into the same retirement account, every year over that same amount of time, you would have over $265,000. Think about that for a moment. All you’re doing is taking your average tax refund and dumping it into your retirement account and suddenly you’ve amassed over a quarter of a million dollars. And this is on top of any other retirement savings you already have and is just a bonus on top of it all. Taking the government’s “free money” every spring and putting it to work before you have a chance to spend it could literally help you obtain the retirement of your dreams.
You may already have retirement contributions under control, so if so, think about other opportunities. If you have children you may want to boost their college savings by putting a little extra into their 529 plans. College just keeps getting more expensive, so a few thousand here and there today could help a great deal in fifteen years.
If college funding and retirement accounts are already chugging along just fine and you’re still looking to invest the money, don’t shy away from regular investment accounts. Sure, you may not receive some of the tax breaks that retirement or college accounts provide, but making money is making money no matter how you slice it. It depends on your goals for the money, but if you’re just looking to create additional income streams, then building a municipal bond portfolio might be the ticket. You can earn regular interest payments that may be entirely tax free. Sure, starting out with just a few thousand dollars won’t generate a ton of income right away, but if you start building an income-generating portfolio today and allow it to grow over the years, you will begin to receive a sizable stream of passive, potentially tax-free income. Again, this is something to consider after you’ve pretty much maxed out all of your other tax-advantaged avenues.
If you’ve been doing everything right and you don’t carry any debt, have a nice savings cushion set aside, and are pumping money into your retirement accounts so that you won’t retire in the poor house, then it may be time to just spend a little money on yourself. There’s nothing wrong with splurging a bit so long as doing so doesn’t hurt you even worse financially. Obviously, going out and buying a brand new HDTV while you’re carrying thousands in high-interest credit card debt isn’t a very good idea, but treating yourself with a little something nice if it won’t put you further in debt isn’t the end of the world.
Just be sure to keep in mind how the purchase will affect your finances in the long run. If you’re splurging just for the sake of immediate gratification while there are more pressing financial issues on the line, realize that what brings you joy today may end up costing you thousands of dollars in the long run. Yes, it’s more fun to do something that makes you feel good right now instead of doing something that may not become apparent for a few years, but trust me when I say you will thank yourself later. While all your friends are bragging about their big tax refunds and all the cool things they are buying, know that they will likely be stuck in this cycle for the rest of their lives while you will come out ahead and will be living without the same financial worries that keep most people up at night.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.
All great points. I did my taxes this past weekend and am getting a refund just below what the average refund is. I plan to save a small part of it and use the rest to pay down my student loans.
Whenever I get large 'windfalls' of money I break it down like you explain above. First ,I do absolutely nothing with it. I just put it in a savings account. Then, I take 5% and spend it however I want. Then I break it down depending on what my goals are. Currently I want to get rid of my student loans, so the majority is going towards that. Otherwise, I'd be investing the vast majority of it.
We plan on doing a bit of all 3. Saving some for a rainy day, investing in an online business, and treating ourselves, maybe to a nice (short) vacation.
@howsmarriedlife I hear ya. I'm still waiting to hear back from my accountant about this year's return, but I think we will be getting a little something back this year. Some of it will probably get saved for some upcoming travel and then the rest will probably go into one or both 529 plans.