If you’re getting a tax refund from Uncle Sam this year, you’re among the many Americans who are. (The 2023 national average, according to IRS weekly filing season statistics, was $2,878). 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 six Do’s and three Don’ts to consider when it comes to your tax refund:
Do #1: 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.
Although savings vary based on your specific situation, applying a $3,000 tax refund toward the current average American household credit card debt of $6,900 would yield substantial savings. Paying a full $6,900 balance off over two years, for example, requires monthly payments of around $330 and would cost nearly $1,000 in interest charges alone, based on an average 14 percent interest rate. Applying a $3,000 tax refund to cut the balance to $3,900 would lower monthly payments to around $180 and reduce interest costs by over $400 in a two-year repayment schedule.
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.
Do #2: Start (or add to) a high-yield 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 a high-yield 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 (A $3,000 tax refund could grow by $650 over five years in a high-interest savings account paying 4.00% APY). 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.
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 (similar to 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. Our term account calculator can help you find out how much your savings will be worth over time (A $3,000 tax refund could grow by $739 in a five-year term account paying 4.50% APY).
If you haven’t started saving for your children’s college tuition and expenses, now’s the time to look into 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.
Do #3: Invest in your retirement with an IRA.
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.
There are two types of IRAs, Traditional and Roth, each with specific advantages based on your tax strategy. Traditional IRAs allow upfront tax-free contributions which are taxed upon withdrawal and Roth IRAs are taxed on the front end with earnings and withdrawals often tax-free. For 2021, the limit on annual contributions to an IRA is $6,000 or $7,000 for those age 50 or older.
Potential realized savings vary widely based on the age you begin contributions, the type of IRA you select, the performance of the investments within the IRA, as well as the age you plan to retire. A $3,000 initial investment in a traditional IRA could grow to $4,502 in five years, $8,856 in 15 years, and $32,030 in 30 years, assuming an annual return of 7.00%, and no additional contributions. Access an IRA calculator to see how much more you could earn with additional contributions to your account. (Consult your financial advisor for more on Traditional and Roth IRAs; because an IRA allows you to choose from a range of investments as opposed to just savings and term accounts, be aware that some investments—stocks, bonds, ETFs, and mutual funds—may lose value).
Do #4: Invest in your home and/or make needed repairs.
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 (and help you avoid a larger repair down the road).
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.
Do #5: Open a college savings plan for your child.
According to the College Board, the current average annual cost to attend college is as follows:
- Public two-year, in district (commuter): $19,230
- Public four-year, in state (on-campus): $27,940
- Public four-year, out of state (on campus): $45,240
- Private non-profit four-year (on campus): $57,570
Save for your child’s college education with a college savings plan. For the most part, withdrawals may have little to no tax penalties when used for higher education purposes. Talk to a licensed investment professional about your options.
Do #6: Invest it.
Instead of just working for money, let money work for you. If you invested one lump sum of $3,000 in the stock market, over 30 years, assuming a 12% return, you’d have $89,879! (Of course, do your research first before making any investment decisions and talk to licensed investment professionals.)
…and now for the Dont’s!
#1. 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.
#2. 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.
#3 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.
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