Summary:
While it’s tempting to spend your tax refund on a whimsical splurge or fancy vacation, consider other ways to make the most of this financial boost. Think of actionable, long-term financial goals so you can use your windfall wisely and fully maximize your tax refund. Paying off high interest credit card balances, if you have them, can be highly productive. But you can also use it to jump start your savings and get on the path to retirement.
In this article:
Evaluate your finances and goals
1. Pay off debt
2. Start an emergency fund
3. Save for retirement
4. Save for a home
5. Treat yourself
Getting your tax refund on a debit card
Set your financial goals
Evaluate your finances and goals
If you tend to get a tax refund every year, you may be wondering what’s the best way to spend that money. “Spending” may not be the best word to use. Instead, your tax refund can be a “springboard” to make smart money moves that can help you achieve your goals.
Perhaps you can ask yourself, “What’s the best way to use this money?” There are infinite options, but what’s best all depends on your situation. Consider your income, expenses, and debt. What are your financial goals and are you achieving them?
Here are 5 ways you can use your tax refund productively:
1. Pay off debt
One of the best things to do with unanticipated or “found” money is to pay off debt, especially high-interest debt like credit cards. Debt can be a drag on your pursuit of financial goals. Paying it off can help you save money and improve your credit health.
If you’re unable to pay off your credit card balances in full each month, you are likely being charged a high rate of interest. Not fully paying off your balance each month is making your purchases exponentially more expensive. If you come into extra cash, like from a tax refund, paying more than the minimum can help you save money and allow you to pay off your balance quicker.
As you pay down credit card debt, it could also help improve your credit health. One important credit score factor is your credit utilization rate. This measures how much of your available balances you’re actively using compared to your credit limits. When it comes to credit utilization, the lower the better. If you pay down your balances, you could see an improvement in your credit health.
How you approach debt payback depends on your goals and situation. Paying back high-interest debt first will save you the most money. Here are some debts to consider paying off in full or partially:
Credit cards
Making minimum payments on your credit cards will keep your accounts in good standing, but interest charges can add up. To keep the interest from accruing, you need to be aggressive in paying off your credit card balances.
If you have multiple cards, you can compare interest rates and prioritize the highest first. Though some people like quick wins and get motivation seeing an account completely paid off. In that case, you could look at which of your accounts have the lowest balances and work to get those down to $0.
You may consider closing the account once the balance is at $0. Just be aware that if you close an account, it could have a negative impact on your credit score. Credit scoring models tend to factor in the average age of your accounts, so closing a long-standing account in good standing may not reflect favorably in your credit score. If having the accounts open makes you more likely to spend, it may still be a good idea to close the account.
Installment loans
Any debt should be considered if you have money to pay it back. Personal loans, mortgages and car debt tend to have lower interest rates than credit cards and are installment loans, so you have a set amount you must pay each month, which includes part of your principal balance and interest. Even though the interest rates may be lower on installment loans, these debts can still feel like an anchor keeping you from certain financial goals. Like credit cards, making extra payments against the principal balance of your installment loans can help you save money and potentially shorten the length of your loan. If you have a mortgage that includes private mortgage insurance (PMI), extra payments may be able to help you build enough equity in your home to eliminate PMI payments faster than they would automatically.
It may not make sense to pay down certain debt if the interest rate you can get by saving the extra money is greater than the interest rate of the debt. For instance, if your mortgage is at a 3% interest rate, but your savings account offers a 5% annual percentage yield, it may make financial sense to save the extra money in a low-risk, high-yield savings account. Because of this, before taking an aggressive approach to pay down your mortgage or car loan, you may want to ensure other areas of your finances are steady first.
2. Start an emergency fund
Motivating people to start an emergency fund is popular advice, and for good reason. Ask 10 financial experts about how much you should have in your emergency fund, and you’ll likely get 10 different ranges.
How much you need in emergency savings depends on your type of job, expected job security, spending and your unique financial needs. A goal of three months of living expenses is a good starting point and as you approach and perhaps pass that milestone, you can adjust as needed or if your needs change. As you work to build your savings, be patient with yourself because it can take time. However, using a tax return can offer you a boost financially. Good habits beget good habits, so depositing your tax return money directly into a high-yield savings account and seeing it grow could be a good motivator to keep going consistently.
Beyond the obvious growth of your savings, an indirect benefit of an established emergency savings fund is that it can keep you out of high-interest debt. If an unexpected expense does come up, with enough in savings, you may not have to rely on a credit card or other type of loan to pay for it. Being able to weather unexpected financial calamities not only helps people stay on track financially, but it can offer peace of mind. It’s hard to put a price on that.
3. Save for retirement
Another smart way to use your tax refund proceeds is to grow your nest egg. Retirement can feel far away, but the earlier you start to save, the more time your money can grow. If your high-interest debt is paid and you’re making progress on your short-term savings, starting or bolstering your retirement accounts, such as a traditional IRA or Roth IRA, can be a wise financial move. Research your options, as these accounts offer different tax advantages.
4. Save for a home
If you want to own a home, saving up for a down payment can provide multiple benefits. The larger the downpayment, the easier it can be to be approved for a loan. And a down payment of at least 20% can make it easier to get a loan and help you avoid private mortgage insurance. What better way to jumpstart this dream than with your tax refund? Knowing you’re making progress toward a down payment can make scrolling through those home buying apps all the more enjoyable.
5. Treat yourself
This advice may seem unorthodox, but if you’ve set financial goals and are consistently sacrificing to achieve them, you deserve to treat yourself on occasion. You may not want to splurge on a luxury item or anything that is going to keep you from achieving your goals, but a little something to remind you that the hard work is for something is appropriate. Perhaps a nice meal or a staycation—you can probably think of something more creative too. You want to keep it within your means and certainly don’t want to pay for it with debt. Achieving financial success is a long journey and it’s important to celebrate your wins occasionally.
You can also consider investing in yourself. Are there certain job-related courses you can take to advance your career? Or perhaps an accreditation or training program that will help you advance. These aren’t traditional investments, but allocating money to places to help you move forward in your career are certainly worthy expenses to consider.
Getting your tax refund on a debit card
Some tax preparers may offer you prepaid debit cards as a way to receive your tax returns. Certain states also provide this option for when you file state taxes. Prepaid debit cards may allow you to receive your tax returns sooner than a traditional check or direct deposit. If you don’t have a traditional bank account, this can be a useful service. However, there are some potential drawbacks:
- Prepaid debit cards may have monthly fees and can require a fee if you need to get cash out of an ATM
- Prepaid debit cards may come with some insurance protections, but it may be difficult to recover funds if your card is lost or stolen
An indirect inconvenience is the barrier prepaid cards may have on directing your tax refund money to one of the goals above. Having money on a card may make it easy to swipe and use your funds for everyday purchase, necessary or otherwise. And if you have ATM fees, there could be an additional cost of withdrawing your money and depositing it into the necessary account, whether to pay off debt or establish your savings. Talk with your tax return preparer to discuss your refund options if you have questions.
Set your financial goals
As it is with all financial decisions, what you do with your tax refund depends on the current state of your finances and the goals you’ve set. You likely have many things you want to accomplish. You can save for multiple goals at once and even save and pay off debt at the same time. If you haven’t yet, waiting to receive your tax refund may be a good time to set some goals, build a budget and determine how you can allocate money most appropriately for you. Use this time as a launch point and keep the momentum going throughout the year by tracking your progress and celebrating your wins.
