Summary:
- Think of actionable, long-term financial goals so you can fully maximize your tax refund.
- Paying off high interest credit card balances, if you have them, can be highly productive.
- You can also use it to jump start your savings and get on the path to retirement.
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Evaluate your financial 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 depends on your situation. Consider your income, expenses and savings goals. What are your financial goals and are you on the path to achieving them?
Here are five ways you can use your tax refund productively:
1. Pay off debt
One of the best things to do with extra 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 paying 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.
Paying down credit card debt could also help improve your credit health. One important credit score factor is your credit utilization. This measures how much of your available balances you’re actively using compared to your credit limits.
Aiming to get your credit utilization to 30% is a good start, but the lower the better. As you pay down your balances, you decrease your credit utilization and could see an improvement in your credit health.
How you approach debt payback depends on your financial 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 on your remaining balance can add up. To keep the interest from accruing, you need to be strategic in paying off your credit card balances Paying off all of your outstanding balances would be ideal, but trying to pay more than the minimum on your cards is a good start.
If you have multiple cards, you can compare interest rates and prioritize paying off cards with the highest interest rate first. However, if you’re someone who likes quick wins and gets motivation from seeing an account completely paid off, 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. But if having the accounts open makes you more likely to spend, it may still be a good idea to close the account.
Installment loans
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. Making extra payments against the principal balance of your installment loans can help you save money by reducing your interest payments and potentially shortening 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, depending on your loan type and lender requirements.
It may not make sense to make extra payments on 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 high-yield savings account offers a 5% annual percentage yield, it may make financial sense to put the extra money in the savings account. With that two percentage point difference, you’re earning more on your money in the savings account than you would be saving by paying off the debt. Because of this, before taking an aggressive approach to pay down your mortgage, car loan or other low interest debt, 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. Here are three reasons why an emergency fund is useful:
Covers unexpected expenses—whether it’s a home repair, medical bill or other unanticipated expense, an emergency fund can help you cover these costs without taking on additional debt.
Provides financial stability if you lose income—if you lose your job or need to adjust your work life, savings can help you pay your bills until you’re able to get back on your feet.
Reduces stress—Knowing you have a financial cushion can help bring you peace of mind, especially when faced with an unexpected expense.
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 expenses not only helps people stay on track financially, but it can offer peace of mind. It’s hard to put a price on that.
How much you need in emergency savings depends on your type of job, expected job security, spending habits and your unique financial needs. A goal of three months of living expenses is a good starting point. 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. Practicing good habits can be motivating, so depositing your tax refund money directly into a high-yield savings account and seeing it grow may inspire you to keep saving consistently.
3. Save for retirement
Another smart way to use your tax refund 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 accountscan be a wise financial move. Research your options. Retirement accounts, like a traditional or Roth IRA, can offer tax advantages, but they may also have deposit and withdrawal restrictions.
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 down payment, 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. If you are planning to save for a home, this is a good opportunity to open a high-yield savings account. Be sure to be aware of any minimum balance requirements to avoid monthly fees.
Boosting your savings and paying off debt is a smart plan if you’re preparing to buy a home. There are multiple factors that can impact your ability to secure a mortgage, including your debt-to-income (DTI) ratio. Your DTI ratio compares the monthly debt payments you owe to your monthly income. A lower DTI ratio can show you have enough room in your budget to handle a mortgage payment.
What better way to jumpstart your home buying 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 counterintuitive, but if you’ve set financial goals and are consistently working 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 reward you for your hard work is appropriate.
Perhaps a nice meal, staycation or taking time to enjoy one of your favorite hobbies. 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
The IRS provides several options for you to receive your tax refund. Direct deposit and a paper check are popular options.
You can also have your refund deposited onto a prepaid debit card. Certain states also provide this option for when you file state taxes. Prepaid debit cards may allow you to receive your tax refund 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
- Some prepaid debit cards may not be able to transfer funds from the card to a bank account
- Check the terms of your prepaid debit card to be sure it can be used to receive a tax return
Talk with your tax return preparer to discuss your refund options if you have questions.
Set your financial goals
As with any financial decision, 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. It’s possible to save for multiple goals at once and even save and pay off debt at the same time.
While you wait for your tax refund, consider setting some financial goals and building a budget so you can determine how to allocate your refund in a way that works 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.
