As of April 9, 2015, the average tax refund for tax year 2014 was $2,815. That’s a fairly significant sum for most of us. What would you do if you had almost $3,000 coming your way?
If you want to use your tax refund to get ahead financially, Certified Financial Planner Andrew McFadden has these three suggestions:
- Pay down high-interest credit card debt
“You’re paying a high interest rate, and you won’t feel financially free until you get it paid off,” McFadden says. “Use your fortuitous tax refund to at least get the ball rolling by making a big dent.”
If you already have a debt reduction plan in place, apply your tax refund to the debt you are currently working on. This can help you retire that debt and move on to the next debt in your snowball or avalanche plan quicker. The faster you pay off your debt, the less you will pay in interest — and the more money you will keep later on.
Whether or not you want to put your tax refund toward the reduction of low-interest debt, like a mortgage or student loans, depends on your situation and your feelings toward debt. If you have already paid off your high-rate debt, it might make more sense to consider how else you can use the money. Paying down your mortgage might be equivalent to a 3.5% return, but what if you could invest the money and potentially see a 7% return? Look at your debt situation and determine what is the best use of your tax refund money.
- Build your cash cushion
One of the best ways to protect against financial catastrophe is to build up a cash cushion of some kind. Your tax refund can provide you with a way to get started. “Everyone should have three to six months of living expenses tucked away in a liquid savings account,” says McFadden. If you don’t have any money saved up, now is a great time to start, he says. And if you do have some money set aside for emergencies, but you haven’t reached your goal, your tax refund can provide you with a little extra help boosting your cash cushion.
Even if you have high-interest credit card debt, it might be worth starting an emergency fund. Financial guru Dave Ramsey recommends starting out by saving $1,000 in an emergency fund to take care of unexpected expenses like car repairs, replacing broken appliances, and health care deductibles. It does you little good to pay down credit card debt if you just have to use your cards later to take care of an unpleasant financial surprise.
At the very least, put $1,000 of your tax refund toward starting a very basic emergency fund and then apply the rest to your debt reduction plan. Having a bit of a cash cushion isn’t just about covering some of your expenses. “The unexpected bonus you just got during tax time can give you peace of mind knowing that you’ll be ready in these unfortunate circumstances,” says McFadden.
If you are well on your way toward debt freedom, and you have a good emergency fund, you might want to decide to invest your tax refund. McFadden suggests using the money to increase your retirement contributions for this year, including starting a Traditional or Roth IRA.
You could also consider putting some of that money in a Health Savings Account if you qualify for one. Using tax-advantaged accounts can protect your earnings in the years to come so that your money grows more efficiently. Even a relatively small amount can be worth investing, especially if you let it sit for a couple of decades.
McFadden says there are other ways to invest your tax refund money. “Use the money toward getting solar panels for your house, which helps lower your electric bill,” he suggests. “Or you can put it toward an advanced education for yourself or your kids.”
Look at how the money could benefit you in the future, and put it toward those goals.
What about having a little fun?
Of course, when many people receive a windfall, they want to do something fun with the money. While a tax refund isn’t often considered a true windfall (technically, it’s your money anyway, since you overpaid in taxes), many people view it that way. If you want to use your refund for something fun, McFadden doesn’t completely rule it out. But he warns against using the full amount of your tax refund for frivolities.
“If you have to spend some of that refund now to reward yourself somehow, spend no more than half,” McFadden says. “I recommend using at least half of your refund toward one of the strategies that will help you make financial progress in your life.”