5 Best Moves To Spend Your Tax Refund
Updated On November 1, 2021
Editorial Note: This content is based solely on the author's opinions and is not provided, approved, endorsed or reviewed by any financial institution or partner.
It’s tax time, and you may be expecting a tax refund this year.
In 2016, the average tax refund was $2,860. According to the IRS, 111 million tax refunds totaling over $317 billion were issued last year.
If you are expecting a tax refund this year, should you save it or spend it?
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You should invest your tax refund and here are 5 smart ways to make an investment in your financial future:
1. Make this the last year you ever receive a tax refund
It feels exciting to get a tax refund. Who doesn’t like receiving their hard-earned money back in their pocket?
But, that tax refund is costing you.
Every day without that tax refund means you are losing out on investing those funds in your financial future.
It’s called the time value of money: a dollar today is worth more than a dollar tomorrow. Why?
You can invest those funds and earn a financial return on your money. Therefore, you prefer to have your money sooner rather than later so that you can invest (and earn interest) or reduce debt (and save interest).
Next year, set a financial goal to eliminate your tax refund. Yes, eliminate it.
When you receive a tax refund, it means that you overpaid your taxes.
When you overpay your taxes, it means that you gave a free loan to the government and never got paid for it.
Think of your tax refund as the government repaying that loan – without paying you interest – by simply giving you your money back. While the government had access to your money, you didn’t.
Contact your human resources department and update your tax forms to reflect your anticipated tax rate and deductions. You can use this year (and perhaps past tax years) as an approximate guide.
You may not be able to eliminate your tax refund completely, but the net result is that your paycheck will be higher each pay period and your tax refund will be closer to zero. This way, you will have more funds at your discretion to invest during the year, rather than waiting for a refund after tax time.
2. Start an emergency fund
You never know when an emergency will strike. Whether it’s an unforeseen medical expense, home repair or unemployment, don’t get caught off guard.
Build a financial foundation with at least six to nine months (or more) of cash to cover expenses. You can use your tax refund to help start an emergency fund if you don’t already have one or add to an existing emergency fund if you do.
Keep this cash in a separate bank account and only break the glass in case of emergency.
3. Pay down your credit card balance
If you have existing credit card debt, you can take two actions steps to get out of debt and save money.
First, you might be able to obtain a personal loan at a lower interest rate than your existing credit card interest rate.
For example, if you have $5,000 of credit card debt at 14% interest and can obtain a personal loan at 6% interest (depending on your credit profile and other factors), you can consolidate your credit card debt and potentially cut your interest payments by more than 50%.
Second, you can use your tax refund to make a one-time, lump-sum payment to pay off your credit card debt. Like student loan debt, make sure that your one-time payment is applied directly to your principal loan balance (not toward next month’s regular monthly payment).
4. Fund A Roth IRA
Use your tax refund to fund a Roth IRA, which is one of the best ways to invest in your financial future.
What is a Roth IRA?A Roth IRA is an individual retirement account that you can fund with after-tax money. You can invest the funds in your Roth IRA just like a regular investment account. Unlike a Traditional IRA, the funds in a Roth IRA grow tax-free since they are taxed upfront.
If you withdraw any funds from your Roth IRA after age 59 1/2, they are yours to keep without paying any taxes. Also, unlike a Traditional IRA, you are not required to make mandatory withdrawals from a Roth IRA at age 70 1/2.
For the 2018 tax year, there are limits on who can contribute (and how much you can contribute) to a Roth IRA.
If you are younger than 50 years old, you can contribute $5,500 per year.
If you are 50 or older, you can contribute $6,500 per year. You can only contribute to a Roth IRA if your adjusted gross income is less than $133,000 for single filers and $196,000 for married couples (although phase outs begin for income at $118,000 and $186,000, respectively).
You can open a Roth IRA with most brokerage firms. You have until Tax Day each year to fund your Roth IRA. This year, income taxes are due April 18, 2018.
5. Make An Extra Student Loan Payment
One of the best strategies to pay off student loans faster is to make an extra student loan payment. Since there are no prepayment penalties on your student loans, you can use a portion of your tax refund to make a lump sum student loan repayment.
Contact your student loan servicer in writing and explain that you want to make a one-time, lump sum student loan payment toward your student loan principal (not to next month’s regular monthly payment).
The more you can chip away at your student loan principal, the more you will save in interest costs.
These 5 “investments” might not be your favorite way to spend your tax refund – but they will help put you on the fast track to financial freedom.