Getting a tax refund this year and not sure what to do with it?
Every year, millions of Americans receive billions of dollars back in overpaid taxes in the form of a tax refund. Many Americans blow their refund on dinners out, new clothes, and presents for themselves. A few use their tax refund to help them get ahead financially.
While it’s best to prepay your taxes accurately with no refund coming — overpaying means giving Uncle Sam an interest-free loan — tax refunds do sometimes arrive as unexpected windfalls. Rather than eat or drink yours away, consider putting it toward building wealth.
You’d be amazed how much difference even a little financial breathing room can make. When you start playing offense rather than defense financially, your financial goals suddenly start looking reachable. In turn, you start getting excited about the direction of your finances — and your life in general.
Before you get carried away dreaming up inventive ways to spend your tax refund, do something to boost your future instead.
How to Use Your Tax Refund Money Wisely
1. Expand Your Emergency Fund
Financial emergencies happen all the time. This month, perhaps the furnace needs servicing for $750. Next month, your car needs $900 in repairs. The month after that, it’s an unexpected medical bill. On a morning that seems like any other, you could arrive at work to learn that a corporate merger left your entire department redundant.
These, among a hundred other reasons, are why you need an emergency fund.
If you don’t have one currently, aim to set aside $1,000 as an initial milestone. Once you reach that, transition to thinking about your emergency fund in terms of how many months’ living expenses it can cover. If you spend $4,000 per month and have $8,000 in an emergency fund, it can cover two months’ expenses.
Aim to set aside between one and six months’ expenses, depending on the stability of your income and expenses. The less regular and predictable each is, the more you need in your emergency fund. Storing that much money can take months or even years if you’re just taking a little bit out of each paycheck, so use your tax refund as an instant boost to your emergency fund.
It’s advisable to open an account at a separate bank to house your emergency fund. Put it in a high-yield savings account – Bask Bank or Simple are great options – where you don’t see it every time you log into your regular online banking. That way, you don’t feel tempted to tap into it for nonemergencies.
2. Pay Off Credit Card Debt
If you can’t pay off your credit card balance every single month, you have a problem that needs resolving.
Credit card debt is extraordinarily expensive, routinely costing between 20% and 25% in annual percentage rate fees. You can’t afford to carry credit debt as you pursue your long-term financial goals.
Try the debt snowball method to knock out your credit card debt quickly. It involves putting all your available money toward your smallest debt first while making the minimum payments on other debts. Once you pay off that smallest debt, you then start putting all your money toward the next-smallest, and the next, and the next.
With each debt you eliminate, you free up more money to put toward paying down the next debt. Hence the “snowball” analogy: It starts small but builds over time.
3. Pay Off Student Loans or Other Unsecured Debts
As you use the debt snowball method to knock out high-interest debts, don’t stop at credit card debt. Keep going to pay down other unsecured debts, including personal loans, payday loans, title loans, debt consolidation loans, and high-interest private student loans.
If a debt has an interest rate of over 6%, aim to pay it off as quickly as possible. You earn a guaranteed return on your investment when you pay off debts. But the money you invest elsewhere only comes with a possible return.
The road to poverty is paved with high-interest debt.
4. Put It Toward a Major Savings Goal
If you already have an emergency fund and no high-interest debt, you can always put your tax refund toward a major savings goal, like a down payment for a house.
While homeownership isn’t a good fit for everyone, the wealth disparity between homeowners and renters remains striking. According to the most recent Federal Reserve’s Survey of Consumer Finances, the average homeowner has a net worth 46 times higher than the average renter ($231,400 versus $5,000).
Plus, homeowners get to do quirky things like painting their bedroom mauve or recreate an ’80s-style arcade in the basement.
Whatever your savings goal, your tax refund can help you reach it faster.
5. Contribute to a Tax-Sheltered Retirement Account
Regardless of your other goals, all people share one common financial goal: retirement.
Even if you wanted to, you can’t work forever. You can’t count on your health remaining strong, and many older workers increasingly find themselves pushed out of their high-income jobs. Nor can you count on pensions or impressive Social Security benefits, either. Among the many ways retirement has changed over the last generation, Americans are increasingly on their own for planning and saving for retirement.
That means you should save for retirement earlier and save more money than you think you need. By securing a comfortable retirement fund before you reach retirement age, you can cut your risk of late-career hiccups and sequence risk from stock market crashes.
Before doing anything else, make sure you maximize all employer-matching benefits through an employer-sponsored plan like a 401(k) or SIMPLE IRA. If your employer offers matching benefits, take advantage of it — it’s effectively free money.
From there, you can either contribute more to your employer-sponsored account or your own IRA or Roth IRA. The more money you can invest tax-free, the less “financial leakage” you suffer in taxes siphoned from your paycheck by Uncle Sam. And the less you’ll owe in taxes this time next year.
Pro tip: If you have a 401(k) or IRA, make sure you sign up for a free portfolio analysis from Blooom. Connect your accounts, and they’ll provide insight into how diversified your portfolio is, whether you have the proper asset allocation, and if you’re paying too much in fees.
6. Contribute to a Tax-Sheltered Education Account
If you have children and plan to help them pay for college expenses, you can also save on taxes through a tax-sheltered education account.
Options include education savings accounts and 529 plans, both of which come with their own distinct tax benefits. Education savings accounts work like Roth IRAs in that you can’t deduct contributions. But the money grows tax-free, and you don’t pay taxes on withdrawals when used for education expenses.
Keep in mind that most 529 plans operate on the state level, which makes them restrictive. While some states allow you to deduct contributions, many place annual deduction limits, and you can’t deduct contributions from your federal tax return. The contributions do grow tax-free, however.
7. Invest Through a Taxable Brokerage Account
Tax-sheltered accounts help you minimize your tax burden, but they restrict the uses of your money. You can’t pull money out of your child’s 529 plan to use as a down payment on a house, for example — not without incurring penalties, anyway.
Plus, tax-sheltered accounts also restrict your annual contributions. If you want to build wealth, you need a taxable brokerage account in addition to your tax-sheltered accounts.
I personally use and like Charles Schwab. They charge no commissions whatsoever, offer plenty of low-cost index funds, and include one of the best free robo-advisory services on the market. You can also check out Betterment or You Invest by J.P. Morgan as other good low-cost options.
Brokerage accounts let you get started with investing with under $1,000. You can invest with as little as $50 if you like. And they make it easy to spread your money among hundreds or even thousands of stocks with a single investment through an index fund or mutual fund.
7. Create a Will or Living Trust
Everyone, no matter how rich or poor, needs an estate plan. Because when you shuffle off this mortal coil, you leave behind possessions, debts, assets, and possibly people who depend on you. In other words, you leave behind a mess your loved ones must clean up for you.
Even with a will or living trust, that mess creates a surprising amount of work. Without one, your legacy becomes one of chaos at best and infighting and legal battles at worst.
You can hire an attorney to draft your estate plan. On the plus side, they can ensure every T is crossed and every I is dotted. The downside is that it costs more money to hire an attorney to draft custom legal documents for you.
If your estate isn’t large or complicated, you may be better off using an online service like Trust & Will (read our Trust & Will review). They won’t break the bank either, potentially leaving more of your tax refund available for more fun uses.
But keep in mind that your estate plan is an evolving animal, not a one-time chore. You need to revisit it every few years, particularly after major life changes such as getting married, having kids, or buying or selling a home.
8. Invest for Passive Income
The holy grail of the personal finance world, passive income is the key to financial independence. With enough passive income, you can cover your living expenses, rendering your day job optional.
In other words, you can retire no matter your age.
Common sources of passive income include dividend-paying stocks, bonds, rental properties purchased through a company like Roofstock, indirect real estate investments like real estate investment trusts and crowdfunding websites, private notes, business income, and royalties from artistic works. The idea is simple: You invest money once, and that investment keeps paying you income for many years to come, perhaps indefinitely.
Imagine you spend around $4,000 per month on living expenses. You invest some money in stocks and index funds, which generate around $300 per month for you in dividends. At a certain point, you buy a rental property, which produces another $500 per month for you. And you invest some money in crowdfunding websites and private notes to generate another $200 of monthly income.
That puts you at $1,000 in monthly passive income, or 25% of your monthly living expenses. As you keep building passive income and approach 100%, working becomes optional, as you no longer need your salary income to live. That ratio of your passive income to your living expenses is called your financial independence ratio or FIRE (“financial independence and retiring early”) ratio, and it’s one of several critical personal finance numbers you should track.
9. Buy Life Insurance
Many adults, particularly those with families and depend
ents, need life insurance. If your family would become strapped financially should you meet your maker, you need life insurance.
If you’re unsure about how much coverage to buy, develop a basic understanding of the different types of life insurance policies available. Run your own numbers on how much life insurance you actually need. Websites like Bestow provide you with a term life insurance quote in seconds, and you can apply in a matter of minutes.
Your family doesn’t need to move into a palace if you kick the bucket. They do need their basic living expenses met. So speak with multiple sales reps and plenty of friends and family about their own life insurance coverage.
10. Start or Grow a Business
Ever dreamed of being your own boss?
In today’s world, it’s easier than ever to start your own business, especially for virtual businesses with few startup or overhead costs. You can even convert a hobby into a money-making business and eventually quit your day job.
Your tax refund alone probably can’t cover the costs of launching a large-scale business, but no one says you need to open a restaurant or buy thousands of dollars in inventory. If you’re new to entrepreneurship, start with a side gig while continuing to work your day job. You can start small and see how you like it to explore what it would take to grow it into a full-time business.
Turn your refund into income for years to come and get a few small-business tax deductions next year as well. And if the day comes when you do want outside funding to expand your business, you have plenty of options available, from business lines of credit to pulling equity from your home to venture capital and beyond.
11. Continuing Education or Certifications to Advance Your Career
Often, investments in yourself offer the greatest returns.
Whether it’s a new certification, degree, license, or some other qualification, use your tax refund to help you reach your career goals. Yes, it costs money and time — hence the word “investment.” But it can lead to that raise or promotion you’ve been angling for or help you secure a new, better job entirely.
It’s all too easy to get comfortable and complacent in your career. But instead of drifting along, get extremely intentional about your perfect job, your perfect hours, and your perfect life. Use lifestyle design to map out your dream destination. Then invest the time and money needed to make your vision a reality.
And don’t put limitations on your dream life. Today’s world features plenty of jobs that let you work from anywhere. You can earn money while traveling full-time. Some jobs even include free housing. My wife and I spend 10 months of the year living overseas, where her employer provides us with a place to live. Meanwhile, I get to work remotely as an online business owner and freelance writer.
It took some work for us to create this lifestyle. But you can truly have whatever lifestyle you want if you’re willing to think long-term and get creative with your lifestyle design.
12. Pay Down Your Car Loan
The sooner you pay off your car loan, the sooner you can rid yourself of that pesky monthly payment.
However, where many people run into trouble here is that once they pay off their car, they simply find other ways to spend the money. Instead, have a plan and invest the money to build wealth.
Note that the interest rate on your car loan should affect your decision. If you have an 8% interest rate, prioritize paying off the car loan if you have no high-interest unsecured debts. If it’s closer to 4% interest, leave the loan in place and invest the money elsewhere.
Because if you can borrow money at 4% and invest it at 7% to 10% – the average historical returns on stocks, depending on which index you look at – it makes sense to do so. Ultimately, the decision depends not only on your interest rate but also on your risk tolerance and investing confidence.
13. Pay Down Your Mortgage
The same logic applies to paying off your mortgage early.
You can save some money on interest by putting extra money toward your principal balance. But home mortgages tend to be even cheaper than car loans, making them the most affordable debt on your balance sheet.
If you feel strongly about paying off your mortgage as quickly as possible, by all means, put your tax refund toward it. But instead of overpaying the IRS with your automatic paycheck deduction, aim for a $0 tax bill with your return by adjusting your employer withholding amount to better reflect your owed taxes. With your higher paycheck each pay period, you can then spread your extra mortgage payments over the whole year.
The biweekly payment option for paying off mortgages faster is particularly effective. Set up automatic biweekly payments with your mortgage lender at half your monthly mortgage payment. Because there are 52 weeks in a year, that comes to 26 half-month payments per year, or the equivalent of 13 monthly payments. Since each month has 4.3 weeks (30 to 31 days), by paying 4.3 weeks’ worth of payment every four weeks, you pay down your mortgage faster without even noticing the difference.
14. Buy Better Health Insurance
Not all jobs come with health benefits. If you don’t receive comprehensive health coverage through your employer, take advantage of your tax refund to buy the best health insurance plan you can.
And don’t be afraid to combine a high-deductible insurance plan with a health savings account (HSA), which you can open with Lively. The combination works particularly well for healthy adults, and HSAs offer the best tax benefits of any tax-sheltered account available. Contributions are tax-free, the money grows tax-free, and withdrawals are tax-free when used for health-related expenses — an umbrella that covers plenty of ground.
15. Book International Travel
According to a 2018 survey reported by The Hill, a shocking 11% of Americans have never left the state where they were born, much less left the U.S. Over half of Americans have never owned a passport.
The world is a big, beautiful, and often surprising place. And it’s easier and cheaper than ever to travel abroad to see more of it.
To keep your trip affordable, and perhaps even within the budget of your tax refund, start reading up on international travel hacks and tips. Look into European countries that are still cheap if you have your heart set on Europe.
But don’t stop there. Many safe and beautiful countries are still cheap enough that Americans could live a comfortable lifestyle on $2,000 per month.
Some of my favorite affordable destinations include Prague, Budapest, Cape Town, Tbilisi, Brasov, Beirut, and Veliko Tarnovo. As you plan out your next international trip, also look into endangered destinations that may not be available to visit much longer.
You can visit the Jersey Shore any time. Push your comfort zone further this year.
16. Give It Away
Building wealth is all well and good, but none of us should forget to give back regularly.
Although the returns on your investment may not be as immediate or measurable as investing in the financial markets, giving to charity benefits your community and gives you a sense of pride and satisfaction. And you can claim the charitable donation tax deduction, which doesn’t hurt.
Plus, Forbes detailed several studies that demonstrated that giving money away doesn’t just make you feel richer. It also makes you feel happier. The boost in mood far outlasts the boost you get by spending money on yourself — yet another reason to ditch the consumption mindset.
Like the idea of giving more to charity, but want to invest your tax refund elsewhere? You can always donate used clothes, donate furniture, donate old electronics, or donate any other personal belongings you no longer use regularly. When in doubt, get it out of the house and give it to someone who needs it more than you do.
On a tight budget, making charitable donations can slip down on your list of priorities. Your refund gives you a chance to give a little back, even if it only serves as a reminder to make more nonfinancial donations.
Whether it’s a significant windfall or just a drop in the bucket, treat your refund like found money. If you’re smart, you can put it to work for you and improve your financial situation. Don’t blow it on some unnecessary or impulsive splurge.
You may already have the funds earmarked for some spending. But before you let your tax refund burn a hole in your pocket, remember the government isn’t sending you a bonus check, but rather money that was yours all along.
Don’t get caught treating your refund check any differently than you’d treat your weekly or monthly paycheck. Give the money a purpose. Think about your long-term financial goals, and use your tax refund to help you reach them faster.
Are you getting a tax refund this year? What do you plan to do with it?
Source: Money Crashers