If you’re getting a tax refund from Uncle Sam this year, you’re among the many Americans who are. (The 2019 national average, according to IRS weekly filing season statistics, was in the neighborhood of $3,000). But before you start spending that refund, pause to reflect on what a sudden influx of cash could do to improve your short- and long-term financial future. Below are some Do’s and Don’ts to consider when it comes to your tax refund:
Do: Lower Your Debt.
If you’re paying less than your full balance every month on your credit cards, you’re not alone—but keep in mind that each month, interest charges are added to your balance… and compounding. If you have high-interest credit cards, loans and lines of credit, this is great place to put your refund. Start with the card on which you’re paying the highest interest rate. Every dollar you pay over your minimum balance due cuts down on the interest charged to you. If you’ve got any loans or lines of credit, consider making an additional payment there as well. You’d be surprised at how much just one additional payment per year can save you on a 30-year mortgage.
Don’t: Consider Your Refund “Found Money.”
Your tax refund is actually money that you’ve been overpaying to the IRS all year. If you received a large refund because you had significant deductions, you may want to consider revising your W-4 form. This can help you keep more of your money throughout the year (and earn interest on it) rather than wait for the IRS to give it to you after you file your taxes.
Do: Start (or Add to) a Savings Account.
Build up a rainy day savings fund, or an emergency savings account with your refund. This can help cushion the financial blow of an unexpected expense like an emergency room visit, a car repair, or even a job loss.
Financial experts recommend having at least three months salary put away in a savings account that you don’t touch unless absolutely necessary. That may seem like more than you can manage, but start small, if need be.
If you put your tax refund money in an interest-earning savings account and add a little monthly or even quarterly, you can grow your savings faster. Our handy savings calculator can help you find out how much your savings will be worth over time. And if you set up an automatic transfer from your paycheck or your checking account to your savings account every pay period, you’re making sure you “pay yourself first” without having to think about it.
Saving for a Goal
If you’re saving for something special, like a car or a down payment on a home, you can typically earn more interest than a savings account by putting your refund in a term account (more commonly known as a certificate of deposit or CD). You choose the term based on when you plan to use the money. If you’re saving for a down payment on a home in a few years, you can get a 36-month term, for example.
If you haven’t started saving for your children’s college tuition and expenses, now’s the time to look in to college savings plans (529 plans). The interest earned on those isn’t taxed by the IRS or by most states. You can find out more about the tax advantages of 529 plans on the IRS.gov site.
Don’t: Make a Down Payment on Something You Can’t Afford.
Maybe with your tax refund, you finally have the down payment needed to get a loan on the dream car you’ve had your eye on. However, do you have enough in your monthly budget to afford the payments (not to mention a possible increase in your insurance premiums)?
A car can be an excellent investment, especially if you’re paying more for repairs on your current car than you paid for the car itself. Just make sure you’re not taking on loan payments and insurance increases you can’t handle.
Do: Invest in Your Retirement.
Even if you have an employer-sponsored retirement plan like a 401(k), you can still have an individual retirement account (IRA). The money you contribute to an IRA is tax-deductible, and can grow substantially over the years. If retirement’s getting close, the IRS lets you make larger tax-deductible contributions once you turn 50 to “catch up” on your retirement savings. And if you’re still in your 20s, remember that it’s never too early to start saving for retirement. This handy calculator shows how much you can save over the decades with even small regular deposits.
Don’t: Get a “Refund Advance.”
This time of year, you’re probably seeing ads from tax preparation companies and lenders for refund advance loans or refund anticipation loans (RAL). Some will even place the money on a prepaid card for easy spending.
If you’re considering a RAL, read the fine print. Some can charge hefty fees and interest. These days, tax refunds can arrive within a few weeks—or even less—after taxes are filed (particularly with electronic filing and direct deposit). So you really don’t get your refund much sooner with an RAL than you otherwise would.
Do: Invest in Your Home.
You really want to use your tax refund to spruce up your home. Before you decide where to put that money, consider what improvements will increase the overall value of your home. A new sofa or artwork will look great. However, you’ll probably take those with you when you move. On the other hand, new appliances, blinds, carpeting and a paint job will help improve your home’s resale value. If your roof, air conditioner, furnace, water heater or other parts of your home are showing their age, a new one could help you raise the asking price on your home.
Whether your tax refund is a few hundred or a few thousand dollars, it’s smart to take the time to review (or set) your financial goals. Once you have these goals, finding the right place to park your money is easy.
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