What Should I Do with My Tax Refund?
Many taxpayers get excited when they discover that they will get a tax refund. In 2016, the average taxpayer refund was approximately $3,000. That’s a lot of money! So, if you’re asking the question “what should I do with my tax refund?” consider these five smart moves.
Adjust Your Tax Withholdings
Before you think about how to spend your refund, step back and think about why you’re getting a refund in the first place. If you receive a refund, you overpaid on your tax responsibility with every paycheck. Essentially, you have given the government an interest-free loan with your tax refund money.
Keep more money in your pocket each week by adjusting the tax withholdings from your paycheck. The objective is to pay the right amount of tax on your earnings so that you have a $0 tax return at the end of the year.
You can adjust the amount of federal income tax withheld from your paycheck by updating the Form W4 with your employer. The amount withheld is based on the number of exemptions you claim. The more exemptions you claim, the less money will be withheld from each paycheck. Zero or fewer exemptions will increase withholdings, which can trigger an end of year tax refund.
Determining the right number of exemptions isn’t easy. The IRS does provide an online calculator that can help you calculate the right number of exemptions. If you need to make an adjustment, ask your employer for a new Form W4 and update your exemptions.
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Start Saving
There isn’t anything sexy or fun about saving money, but it can give you peace of mind, help you reach personal milestones, and provide greater financial stability and independence.
A rule of thumb about savings—you should have enough money that is easily accessible to cover one to three months of living expenses. To calculate this amount, add up your monthly payments. These can include housing, heat, food, utilities, insurance, transportation, school loans, health care, child care, entertainment and more. One month of living expenses could equal $3,000—the average taxpayer refund. A regular savings account is a great place to start saving for this rule of thumb.
You can also save your refund for future dreams of a wedding, a new home, higher education, a new appliance, or traveling across the country. To save for these types of future milestones, look for accounts that offer a higher interest rate. Usually, you will have to give up access to your money for a period of time in order to get the higher interest rate. A Certificate of Deposit (CD) rewards savers with higher interest rates based on the term and the amount of time you are willing to keep your money on deposit without touching it. Interest rates typically increase the longer the term, which can range from six months, to one, two, three, four, or even five years.
If you want to add your tax refund to existing savings and get as much bang for your buck as possible, opening a money market account might be a good move. These accounts typically reward savers based on the total amount saved in the account. The more saved in the account, the higher the interest rate.
What’s nice about these options is that all are offered as federally insured accounts. No risk. You won’t lose any of your savings.
Pay Down Debt
This move pays off in many ways. It removes a huge weight from your shoulders, results in fewer interest fees, and can help your credit score.
It’s best to prioritize which loan to apply your refund based on whether the debt is good or bad. A good debt is a loan that invests in you—like a student loan or a mortgage. Bad debts are those loans that you obtained for something that perhaps could have waited until you had the money for the purchase. Credit cards and personal loans primarily fall into this category.
If you have more than one type of bad debt, choose to apply your refund to the card/loan which has
- the highest interest rate,
- the smallest balance,
- or has reached its maximum balance.
Each type of payoff presents a different benefit. You can reduce the cost of borrowed money by paying high-interest rate debt first. You can eliminate a loan altogether quickly by focusing on one debt at a time. And you can maximize future borrowing potential while keeping a healthy credit score.
In terms of good debt, using your refund to make an extra payment toward your mortgage each year will help pay down the loan faster. This will reduce the term, and you’ll save on interest payments.
Invest in Your Retirement
You’ve been able to pay your bills, save, manage debt, and live happily throughout the year without access to your tax refund. Investing in your retirement might be the next best move. The future value of $3,000 today will triple at the end of 20 years, earning a conservative 6% return. If you received that average tax return over the same 20 years and deposit it each year into the same piggy bank, the total future value will grow to $126,000!
This is just an example of how your investments can grow with time. Working with a professional investment advisor is the best way to navigate the many options for growing your retirement account. You don’t need a big nest egg to start working with an advisor.
Treat Yourself to Something Special
There is nothing wrong with keeping some of your tax refund after giving yourself a treat. Go out to dinner, visit a spa, join a gym, get a make-over haircut, or get tickets to your favorite show or game.
Tax time is a good opportunity to add a new discipline and improve your overall health and wellbeing.
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