The average American federal tax refund is approaching $3,000. That’s a sizable chunk of change that hits bank accounts. For many households, it might be the largest lump sum of cash to hit their bank account for the year. Its worth asking what should one do with that refund?
Everyone knows that paying down debt and building up savings is the prudent thing to do. In fact, research shows that most people in fact do use their refunds responsibly. But lets say you’re like I am, and you have competing responsible uses for your refund. Is it better to pay of the car loan or the credit card? Is it better to save the money in savings account or put it into an IRA? At what point should one feel okay splurging a bit?
Make this the year that you turn your tax refund around and put it to work for you. I’ve creating the following handy list of priorities. This generally applies to all savings, and I think it works well for deciding how to spend your tax refund:
- Establish a basic emergency fund. If you don’t have $1,000 or $2,000 set aside in a bank account to cover life’s unexpected expenses, take that refund and create such an account. Having an emergency fund even if its not the recommended 6 months expenses goes a long way towards establishing financial security. Sure, 6 months expenses is ideal, but having this mini fund set aside is the first key step. If you’ve already got this set aside, then . . .
- Pay down high interest revolving debt. Read: credit cards. It doesn’t matter whether you’re using Dave Ramsey’s snowball method or the high interest first method, just do whatever you can to get rid of that credit card debt. The interest rates are killing your ability to achieve financial independence. If you have no credit card debt, then . . .
- Create a full emergency fund. The size your fund will depend on your specific circumstances, but for most people it should be somewhere between 3 and 12 months expenses. If you already have an adequate emergency fund, then . . .
- Contribute to your 401k up to the match. Its free money, so you might as well take it. Many plans will match up to 5% of your salary dollar for dollar, while some plans will match 50 cents on the dollar up to a certain limit. Whatever it is, make sure to get whatever free money your employer is offering. Side note: If you decide to fund your 401k only up to the match, make sure that you either spread your contributions out over the year to receive the full benefit of the match, or ensure that your company offers true up contributions.
- Open an IRA. Or if you already have one, contribute to it. If you’ve already maxed out your 2016 IRA contribution, you can contribute against your 2017 limit, thereby reducing your tax bill next year as well! The question of Roth vs. traditional doesn’t matter so much as the mere fact that you’re putting money in some form of IRA. If you’ve already contributed to your IRA (or have a concrete plan for funding it), then . . .
- Pay down other, lower interest debts. If you’re still holding a car loan or personal loans, use your tax refund to pay them down. Of course, you can pay down your mortgage and your student loans as well, but because these loans are often tax deductible its better to pay down the nondeductible loans first (all other things equal).
- Max out your employer-sponsored 401k plan (or equivalent). If you’ve made it this far, then you already have a plan in place to receive the full match from your employer. If you’re at this point and still have tax refund dollars burning a hole in your pocket, keep funding that 401k. The contribution limit for 2017 is $18,000.
- Fund your child’s 529 plan. If you’ve made it to this step, your financial house is pretty well in order. Only if your personal finances are straight should you set money aside for your child’s future college expenses. Most (if not all) states offer some form of 529 plan. These plans are designed to offer both state and federal tax benefits. On the state level, you can usually claim a state tax deduction, with certain limitations, on the contributions you make. On the federal level, the money growing in your 529 plan grows tax deferred, and distributions are tax free.
- Splurge a little. If you have an emergency fund, your debt is paid off, your IRA/401k accounts are funded for the year, and you’ve funded a 529 plan for your kids, you’ve earned a break. Take that tax refund and splurge a little bit. But remember don’t buy things just for the sake of having things. Instead, use that refund to create memories. Take a trip, ride a zipline, or rent a cottage in the woods for a weekend. You’ll remember those sorts of expenses much more fondly than a new TV, Playstation, or car.
- Change withholdings. Last, but not least, think about changing your tax withholdings so you don’t have such a large refund next year. Remember, when you get a large tax refund back, you’ve essentially been loaning money to the IRS interest free since the year before. Interest rates suck today, but they’re still well above 0%! So don’t loan free money to the IRS, change your withholdings and put that money to use now instead of one year from now.
Do you have any other financially sound ideas for what to do with a large tax refund? Leave a comment below!