If you got a tax refund this year, think twice about spending it on something frivolous. Could you use it to pay off debt, boost your emergency fund, or another future goal?
If Uncle Sam owes you a refund this year, you may be envisioning how you’ll spend your windfall—an evening out, a new tablet or smartphone, maybe even a weekend away. But before you start rewarding yourself with your expected tax refund, take a minute to think about where that money is coming from. In truth, a tax refund is not a reward: It’s a refund of your hard-earned money because you paid too much in taxes last year.
If you’d kept that money over the past year rather than essentially loaning it to the government (interest-free), you would probably have used it to help accomplish your financial goals rather than simply blowing it. So as you anticipate that refund, it’s a good idea to think about strategic ways to use it that will get you closer to your objectives.
“Just like anyone can sign up to run a marathon, only those who plan and prepare for the race are consistently successful,” says Cory Schmelzer, CFP®, principal at San Diego Wealth Management. “Can you run a marathon without training? Maybe. And maybe your tax refund will somehow enhance your financial standing without your planning and preparing for it, but it’s unlikely. Better to think through some of the options available to you, make a plan, and execute.”
Here are five smart ways to make the most of your tax refund.
- Pay off debt
If you have outstanding credit card debt or other consumer debt, consider using your tax refund to pay it down or pay it off. Getting rid of debt frees up money to help you get closer to reaching your financial goals. “Paying off debt has the effect of improving your cash flow on a monthly basis, saves money on interest payments and improves your credit score,” Schmelzer says.
- Build your emergency fund
If you don’t have three to six months’ worth of living expenses saved up and at your disposal, put some or all of your tax refund toward building an emergency fund. It’s important to have a substantial amount of liquid assets to cover unexpected emergencies, such as a job loss, a new transmission, or a furnace repair. If your household has two incomes, three months’ worth of living expenses may be adequate, but for single-income households, try for six, says Keith Klein, CFP®, of Turning Pointe Wealth Management in Phoenix.
“It’s uncomfortable to keep that amount of cash in a savings account, as the rate of interest on many such accounts is so low that you actually lose purchasing power,” Klein says. “A financial advisor can help you locate ways to create an emergency fund with sufficient liquidity, and risk according to your tolerance.”
- Contribute to a retirement fund
If your emergency fund is stocked, think about using your tax refund to help save for your retirement. If you have an IRA, try to make the maximum contribution. Payments to a traditional IRA are tax-deductible, which will reduce your tax bill next year. And contributions made to a Roth IRA will reduce your tax burden when you reach retirement age. Or, if you have a brokerage fund (or want to start one), consider investing your refund in stocks, bonds, or mutual funds that can grow until your retirement.
- Create an opportunity fund
Similar to Warren Buffett’s strategy of keeping cash available to take advantage of excellent investment opportunities when they come along, Schmelzer recommends starting a fund that will provide money for great opportunities that may come to you. For instance, these funds may be spent on opportunities such as investing in a great start-up company, purchasing an undervalued piece of property, or buying a house if you don’t already own one.
- Make a payment toward next year’s tax bill
If you expect your income to increase during the current year, consider making a quarterly payment for this year’s taxes, which will decrease the amount you will owe next spring, Klein says. Or if you’re on track with your financial goals, consider making a charitable donation. You’ll help support a cause you care about and lower your tax liability for next year.
While it can feel good to receive a tax refund each spring, your money can actually work better for you if you hold on to as much of it as you can in the first place. If you find that you’re always overpaying the IRS, consider adjusting your withholdings so you can keep more of your money throughout the year. “Large tax refunds are the result of a taxpayer making an interest-free loan to the government, an action which is probably best avoided,” Klein says.
Freelance journalist Nancy Mann Jackson writes regularly about personal finance, small business, health care, and education. Her work has appeared in Entrepreneur, CNNMoney.com, Bankrate, Working Mother, and many other publications. She lives in Alabama with her husband and their three boys.
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While Society of Grownups hopes the information is useful, it’s only intended to provide general education. It’s not legal, tax, or investment advice, and may not apply or be useful to your specific financial situation. If you need recommendations geared to your personal financial situation, schedule time with a financial planner.