What to Do with Your Tax Refund
by Debbie Baker, CFP
Have you received or expect to receive a tax refund this year? If so, it might feel like an unexpected bonus or windfall. While it can be tempting to spend the funds quickly, a better alternative is to use the funds to strengthen your financial foundation and make progress toward longer-term financial goals. Using a refund intentionally rather than impulsively or frivolously can turn a one-time payment into a solid measure of economic security.
Before deciding how to spend your refund, first assess your overall financial situation. Do you have pressures such as high-interest debt or an insufficient emergency fund? The following explores practical ways to use your refund to better your monetary situation.
Emergency Fund
An emergency fund is the first line of defense against job loss, medical expenses, or unexpected repairs. If your emergency fund is insufficient, a tax refund can be an excellent opportunity to boost it. For those still working, an emergency fund of three to six months’ take-home pay should be maintained in a low-risk account such as a savings or money market account. While there are many variables in determining how much should be saved, six months of take-home pay for a primary income-earner is considered best practice. Three months should suffice in situations where a current salary can easily be replaced, or if a spouse or partner has a dependable salary. Single, self-employed individuals should strive to maintain a fund of six months, and everyone should ensure that insurance deductibles can be covered in the event of various emergencies. Since retirees often rely upon investments as a source of income, they should strive for a higher amount – often 12 to 18 months – to allow for withdrawals in down markets.
High-Interest Rate Debt
Avoiding high-interest loans such as revolving debt (credit cards, high-interest car loans) is critical to financial success, so applying a refund to such debt is wise. There are various strategies for paying down debt, but a good rule of thumb is to pay down the highest interest loans first and consolidate debt into the lowest-rate loan available. By eliminating such debt, monthly cash flow strain is alleviated, and thousands of dollars can be saved in long-term interest. Keep in mind that all debt is not “bad” debt; financing something that appreciates in value (such as a home or property) is acceptable, while items that depreciate (such as a car) should be paid off as quickly as feasible.
Invest
Use your refund to start or add to an investment account. Investing creates wealth by providing opportunities in the market to earn higher returns in exchange for taking reasonable risks, whether in advisory accounts or retirement accounts. Investing requires a long-term commitment and means routinely depositing money into accounts. While an influx, such as a refund, provides a lift, the continued use of automatic deductions is ideal for additions, because it is much harder to miss what you do not see.
Invest in Yourself or Your Home
A refund provides an excellent opportunity to pursue a professional certification or finish the few classes needed for a desired degree. These achievements can allow for higher earning potential. It also can lead to a greater level of saving and investing, which in turn provides for a more secure and comfortable retirement. Similarly, investing in upgrades or necessary repairs to your home that adds value or energy-efficiency helps protect or enhance its value.
While there are many good uses for tax refunds, a refund is not necessarily a financial win. Why? Because it means you overpaid your taxes throughout the year, providing the government with an interest-free loan with your money. Those extra dollars could have been working for you, helping with cash flow, as well as with all the items mentioned above. And while a refund provides a short-term sense of relief or a forced savings effort, a smaller refund – or better yet – owing a modest amount – signals more accurate tax withholding and better control over your finances. So, the goal is not a sizable refund; the goal should be keeping more of your money in your pocket and putting it to work intentionally.
For guidance, contact our experienced, professionals in Wealth Management at The National Bank of Indianapolis.