You’re Getting a Tax Refund… Now What?
A bigger TV. That beautiful vacation destination. A new car. An updated gaming system. New furniture. These are all things that might spring to mind when you when you think about how to spend your tax refund.
According to the IRS, the average 2016 tax refund was $3,053. That’s a sizeable amount, one that could be used in a dozen fun ways.
But instead of focusing on the fun you could have today, think about what you could do with your refund to give yourself a better tomorrow. We have five smart ways to spend your tax refund that will put you a path toward building a nest egg. These include paying down debt, building your savings and investing in your family’s future.
What Is a tax refund? (Hint: It’s not the government’s money)
There can be some confusion about what a tax refund, or a tax return, actually is.
A tax return is the actual form you or your tax preparer use to file your taxes.
A tax refund is the money you get back from the government.
And, people may answer the question of what is a tax refund differently. Some people think that a tax refund is money being given to them by the government. This is not the case.
We’ll answer the question with a scenario. When you start working at a new job, one of the first things you do is fill out paperwork telling your workplace how much of your paycheck you want to be sent to the government to cover your federal and state taxes. Then, using your end-of-year tax return, the government determines whether you gave them too much money, or not enough.
If you paid too much, you get a tax refund – this is the government returning money to you that was yours in the first place.
While the process of sending your money to the government, only to get some of it back, can seem like a hassle. But, it can work in your favor in many ways. Since your workplace sends the government your tax money before you ever see it, you don’t have to worry about not having the money to pay your taxes when tax time arrives.
Think of it as a budgeting tool that saves you time and worry at the start of each new year.
And as a bonus, getting some of your money back means that you can use our tax return tips to take the money you worked for and have that money work for you!
Why you should invest your tax refund for tomorrow rather than treating yourself today
According to David Weliver, founding editor of Money Under 30, “The biggest mistake I see people make … is treating [bonuses and tax refunds] as ‘found’ money instead of earned money. Research shows we’re more likely to spend a windfall frivolously than money we’ve earned. This is especially true of money we weren’t expecting,”
To put it another way:
Let’s say you find a 20-dollar bill on the ground. Since you didn’t have to work for it, and didn’t expect to find it, you’re much more likely to use it to have some fun, rather than to save it to pay for groceries or add it to your car payment.
If you receive $20 as part of your paycheck, however, you’re far less likely to spend it on something frivolous and more likely to spend it on household expenses.
By thinking of your tax refund as money you worked for—which you did—you’ll be more inclined to use it in a manner that will help your future self.
The simple act of taking your tax refund and putting it into a savings account, for example, will give you a cushion in the event of sudden unexpected expenses, whether it’s medical bills, a car repair or any other bills you weren’t planning on having to pay.
And, in the event you don’t have an emergency? Saving up a few years’ worth of tax refunds might allow you to buy a new car or afford a nice vacation without having to go into debt to do it.
5 wise things to do with your tax refund (that will help you in the long run)
Although putting your tax refund away for a rainy day is an excellent idea, there are multiple ways that you can invest your refund that can have even longer-term positive effects on your household’s bottom line.
Here are five smart ways to spend your tax refund that can improve the financial state of your household today and tomorrow.
1. Pay off high-interest debt
While we sometimes think of our debts as just another bill, paying debt sooner than expected can have huge dividends. A couple of excellent places to start when it comes to paying down your debt include:
Credit Cards: Paying off a high-interest credit card can save you an enormous amount of money in a very short period of time. And better yet, it’s easy to understand just how much you can save. If you have a card with 24 percent interest, for example, that means every dollar you pay off today gives you return of 24 percent. Most investments can’t even come close to that number.
Mortgages: Another major debt to consider paying off early is your mortgage. Many people with a 30-year mortgage simply make their payments for 360 consecutive months, often doubling the cost of their home in the process. For example, a $200,000 home with an interest rate of 5 percent will eventually cost the buyer $186,512 in interest.
Simply by making one extra house payment per year, the house would be paid for in 26 years, and the owner will put an extra $32,699 back into their pocket.
Student Loans: The average class of 2016 graduate has $37,172 in student loan debt with an average monthly loan payment of $351. It’s not uncommon for graduates to finish paying off their student loans just as their children head off to college and start accumulating loans of their own.
Much like your mortgage, putting money into paying off the principal of your student loan can cut way on your interest payments. If you have a small loan, you can sometimes even pay off your loan completely before any interest comes due at all.
And remember: If you have personal or student debts you want to consolidate in order to lower your interest rates or make them easier to pay, Greater Alliance can help.
2. Make an emergency savings fund
While this process can be as simple as putting your tax refund into savings and leaving it alone, it’s generally better to plan for future emergencies by creating a specific emergency savings fund.
Most financial advisors feel you should have three to six months’ worth of expenses in an emergency fund, with some advisors recommending 24 months’ worth. Having this money available can be a lifesaver in the event of major medical expenses, an extended job loss or the loss of a vehicle in a car crash.
Unlike, for example, a personal loan, or a taking a second mortgage on your home, using this money has no long-term effects on your budget, like high interest rates or the need to pay a loan back within a set time period.
However, having a large cushion of savings and also carrying, for example, large credit card debts is probably not the best use of your funds. As noted earlier, in that event you’re losing a lot of money to interest, you’re better off paying your credit cards before creating a large savings cushion.
That said, having at least some kind of cushion is always wise. So, if your rebate is, for example, $3,000, consider setting $1,000 in an emergency fund and using the other $2,000 to pay down your credit card debt.
3. Prepare for the future
If you’ve got a handle on your debt and have built up an emergency fund, there are a number of ways you can contribute to your future financial health—often tax-free!
Retirement Funds: Another possible way to use your tax refund is to raise the amount you contribute to your 401(k).
While your week-to-week paycheck will be smaller, you can use the money from your tax refund to make up the difference.
There are multiple benefits to doing this. If your company matches your 401(k) contributions all the way up to 6 percent, bringing your paycheck contribution up to 6 percent means you’re already doubling what you’re saving for retirement. And since your contributions are taken out of your check before they’re being taxed, your financial reward is actually higher than the 6 percent you’re earning.
As a bonus, unlike your credit card, any accrued interest works in your favor.
College: If you’ve got a future college student (or two, or six) in your home, you might consider putting your tax refund in to a 529 plan. If you’re not familiar with the term, a 529 plan allows you to either invest your money in a manner similar to that of a 401(k) or to pre-pay your student’s college tuition.
Regardless of which option you choose, as long as you use the money for college, all 529 plans feature a number of tax breaks, helping you save additional funds as you invest in the future of your favorite students.
Personal Investment: Your children aren’t the only people who can benefit from your educational investment. Consider taking some adult education courses and raising your earning potential. This can take many forms, anything from finally earning your master’s degree, to taking computing classes, to learning a new language.
Anything that makes you a more valuable employee can increase your value to the business world over time, opening up multiple new and exciting opportunities in the job market.
4. Invest in the stock market
The stock market can be a fantastic way to turn a little money into more money, helping you build your nest egg. Keep in mind, however, that the stock market can go through shifts, some slow and some sudden, and there’s always a chance you could lose the money you’re investing.
So, take your time, do your research and look for stocks that that have been making smaller increases over a longer period of time.
If you’re looking for a less complex investment option, Greater Alliance is happy to speak to you about IRA options.
Always remember that your first “investment” should always be paying down your debt, especially if it’s a high interest loan or credit card.
5. Give to charities or people in need.
If you’re already financially secure, you’ve paid off your debts and you already have a healthy investment portfolio, consider giving some of your money away each year, either to charities or to a group of people in need. Give enough away this year, and you may even be able to write off part of your donation on your taxes, allowing you to compound your gift by giving more away next year!