You may dread preparing your paperwork to file a tax return. But most taxpayers can rejoice a little—tax time also means extra income.
The IRS reports over 70% of taxpayers received a refund in 2019. On average, they got $2,781, which was down a little from the $2,825 average in 2018.
An extra $2,781 could still be a significant amount of money, especially when many Americans don’t have even $400 in savings. If you’re one of the many taxpayers who are expecting to get some money back, having a plan could help you make the most of your refund.
Set Aside Your Spending Money
Pay yourself first, meaning put money into an emergency fund or retirement accounts first. This is often the personal finance mantra when you’re budgeting a paycheck. A similar approach could apply to windfall gains, such as a tax refund, as well. But realistically, many of us have pressing expenses—like high-interest credit card debt or needed car repair—that we should prioritize over retirement savings. Here’s your chance to get it done.
You may also want to take a little bit of the money and spend it on something fun. Rather than feel guilty or unsettled by the urge to splurge, set aside a portion of the refund, such as 5 to 10%, to spend however you want. Knowing that you’ve got some play money, you can then focus on how to use the rest of your refund.
Let Your Money Flow Down the Waterfall
In order, here’s a checklist of ways you might use your refund to help you get into a better financial situation. You can think of this list as a waterfall.
After you fill up one level by paying off debts or hitting your savings or contribution goals, your money can flow down to the next one.
Pay off high-interest debts. You could be making large interest payments on credit cards, payday loans, and other subprime debts, like a high-rate auto loan. Once you wipe out these debts, you’ll have fewer bills to think about and you can reassign the money you save each month to other parts of your budget. Paying down or off debts may also help your credit score, which could help you qualify for lower-rate loans in the future. There isn’t a specific interest rate that counts as “high,” but you could use 6 percent as a cutoff point.
Build up a three-month emergency fund. Having an emergency fund can provide a sense of financial security and save you money in the future. When an emergency strikes, and inevitably one will, you dip into the fund rather than borrowing money or using a credit card. Varo recommends saving until your emergency fund can cover your necessary expenses for three months.
For example, your rent, medical insurance, transportation, and food might add up to $2,500 per month. That means you’d want to have a minimum of $7,500 in a savings account as your emergency fund. A great way to build your emergency fund is to set-up direct deposit into a savings account, a direct 10 percent (or more) of each paycheck directly into savings.
Save for retirement. Now, you can look for ways to increase your retirement savings in addition to your 401(k) if you have one. You may be able to contribute up to $6,000 ($7,000 if you’re 50 or older) to a tax-deferred individual retirement arrangement (IRA). Also, take a look at a Roth IRA, if you’re under the income limits ($124,00 to $206,000, depending on your tax-filing status)..
With a Roth, your money grows tax-free and you don’t pay income tax on withdrawals when you start tapping it in retirement. Low-to-moderate income taxpayers may also qualify for the Saver’s Credit, which could lead to an even smaller tax bill or larger refund next year.
Pay off low-interest debts or invest in non-retirement accounts. Congratulations, you’re doing pretty well financially if you’ve paid off high-interest debts, built an emergency fund, and maxed out your retirement savings contributions. The next step could depend on personal preferences.
Some people may want to pay down low-interest debts (perhaps your student loans); others think they can come out ahead by investing their money rather than pay down low-interest debts. There’s no correct option, so weigh your choices and choose the one that feels right to you. You can always save your money in a cash savings account while you decide what to do with it.
A Few More Options to Consider
Focusing on debts, cards, and other types of financial accounts can be good general advice, but your individual situation may call for a different approach.
For example, you may want to pay for a certification or training course that can help you get a raise, promotion, or start a new career. Investing in your personal capital can lead to substantial long-term returns, especially if you’re still early in your working life.
Or, perhaps you know you’ll be traveling for a wedding, important birthday, or holidays in the coming year. Starting your travel fund now could help you avoid putting those trips on a credit card later. Although if you already have high-interest debt, you still generally want to pay that off first.
No matter how you decide to use your refund, consider the overall net effect of your choice. Take a little money and use it for something that’s just plain fun, and then try to find ways to decrease your bills or increase your income.
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Louis DeNicola is a freelance personal finance writer and credit enthusiast. You can find him on Twitter @is_lou.
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