Americans are earning, on average, a tax refund of over $3,100 each year. That’s a lot more than pocket change. Just think of what progress you could make toward your financial goals with an extra $3,100 each year to throw at them.
On the flip side, if you don’t take time to make a plan for how to best spend or allocate your tax refund and you receive one that’s worth a few thousand dollars, you could quickly fall into the trap of extravagant spending that won’t move you toward financial health.
Instead of wasting your tax refund on an impulse purchase or your latest, favorite tech gadget, consider a more deliberate way to spend your refund, and of course, as you read our post on this topic, remember that because everyone’s personal financial situation is unique, you should consult your tax advisor before taking any actions that would impact your tax situation, return or refund.
Is a Big Tax Refund Really a Good Thing?
Start with this question: Should you be getting such a big refund?
While you might be thinking that nothing could be better than a tax refund of a few thousand dollars, that might not necessarily be the case. John Hughes, a private wealth advisor at Ameriprise, recommends conducting a paycheck check-up. “Refunds are money that you have lent to the IRS for the past year – interest free. This falls under the ‘know yourself’ rule.”
Getting a ton of money on your tax return may seem like a way to force savings that otherwise might not occur. “This gives you a pool of money in the beginning of the year that you’ve saved,” says Hughes. “And there’s nothing wrong with this approach.”
But there’s another tactic that might pay off better in the long run. “If you have a big refund,” Hughes says, “you can often decrease the amount of taxes that are being withheld from your paycheck and increase the amount you’re applying towards your 401(k) contribution. It could create a neutral paycheck, but now you’re paying yourself more into a pretax investment that is effectively reducing your year-end taxable income.”
That’s a savvy approach – and perhaps one of the best ways to spend your tax refund. If however, you feel more comfortable continuing to receive a hefty refund each year, understand that it requires discipline to make sure you use your money wisely. That wisdom starts with creating a plan ahead of time for how you will spend your tax refund when you receive it.
Making a Plan
According to Bankrate.com, Americans who have plans for how to spend their tax refund will either pay down debt, save or do something impulsive like spend it all on spur of the moment purchases. Here’s what your neighbors might be planning to do with their tax refunds this year:
- 30% will pay off debt
- 28% will save or invest it
- 26% will apply it to daily necessities (like utility bills or food)
- 7% will go on a spending spree or take a vacation
Some of those plans make sense. Here is some more detail on a few of those ideas and a few other ways you can consider distributing your tax refund dollars.
- Pay down debt. Instead of thinking of the money as ‘free,’ approach it as a raise. Resist the urge to reward your need for instant gratification; rather, pay off nagging debts to free up more monthly income and point yourself in the direction of financial success.
- Generate financial security. Finally start that ‘rainy day’ fund to cover three to six months of expenses.
- Have you always wanted to start an investment portfolio but haven’t gotten around to doing it yet? Use the tax refund to begin and give yourself the best opportunity possible to watch your investment grow.
- Start a college fund. If you’re finding it hard to set aside money for your children’s college education, consider using some of your tax refund. It may even give you the motivation you need to continue investing money each month into their future.
- Have some fun with the money – but be smart about it. As a rule of thumb, engage in fun activities that offer long-term enjoyment or benefits. For example, taking a vacation with your family may bring some much-needed time together and rest, and leave you with lasting memories. On the other hand, spending a little here or there on unremarkable purchases may lead to a dried-up tax refund and nothing of value.
- Start a car fund. Will you need to replace your car in the next year or two? Using your tax refund as seed money for a down payment can be a great way to reduce your total out of pocket costs.
Before your tax refund gets deposited into your account, come up with a strategy that builds wealth, leaves you with great memories, and propels you into the next year on solid financial ground.