Smart Uses for Your Tax Refund

Around 80% of federal tax returns filed result in a refund, and the average refund is around $3,000. That’s a pretty nice sum that can go a long way toward improving your financial well-being! If you expect to receive a refund check, consider how you can maximize its effect on your personal finances. Here are several ways to put the cash to good use.

Interest rates both help and hurt us financially. Earning a good rate of return on our money is a key to building wealth, however paying off high interest rate debts is equally important. Using your refund to pay off a balance with an 20% interest rate is just like earning 20% on your investments — an incredibly valuable use of the money! And unlike an investment, the value is guaranteed since you know the interest rate ahead of time! A $5,000 debt on a credit card at 20% costs you $1,000 every year in interest charges.

Start by paying toward small balances, the type that could be wiped clean within a year or so, regardless of interest rate. In the shorter-term interest rates don’t have as big an impact, and knocking out these small debts can free-up cash flow for other uses. This may be a credit card, a personal loan, a line of credit, or a small car loan. If there is anything that you can pay in-full, get that debt out of your life. That’s one fewer monthly payment, and you can use that extra money each month to increase savings or to pay off another debt faster.

Focus next on your larger debts ranked by interest rate. These are debts that may take a few years to pay off like a student loan, a car loan, a large credit card balance, or a mortgage. A $10,000 debt at 20% costs $2,000 every year while the same $10,000 at 5% costs just $500 per year. There are various strategies when it comes to becoming debt-free, but generally speaking, when comparing two debts it makes sense to pay the smaller balance debt first if the interest rates are close, and to pay the higher interest rate debt first if the balances are close.

It’s a good idea to keep three to six months’ worth of living expenses in an emergency fund so you don’t land in debt or have to raid retirement funds if you have an unexpected expense or job loss. If you’ve had to tap the fund recently, you can use your tax refund to help build the account back up. You can keep your emergency fund in a money-market account or savings account that might earn some interest, but earnings aren’t the point. The purpose of this account is to be easily accessible when needed so you can avoid having to make more detrimental financial decisions in that moment.

If your emergency fund is adequate, you can set aside money for planned savings. This is money for upcoming expenses that you know about like a vacation, a new car, or another major purchase. Saving up ahead of time rather than using your credit card or taking on debt avoids interest charges and is a good habit for building wealth. You may also start saving for holiday gift-giving or to help with other short-term goals, such as a down payment on a home.

We all have projects we’d love to complete, but they get placed on the back-burner. For example, your refund alone may not be enough to redo your kitchen or bathroom, but it can pay for some smaller home improvements or deferred maintenance. Use the extra cash toward projects that may increase the value of your home like a new patio and landscaping, upgrading a kitchen counter, or refreshing your cabinets with paint and new pulls. Or focus on needs that could save you money like replacing an aging furnace with an efficient unit or installing a programmable thermostat.

You can contribute up to $5,500 to a Roth IRA for 2018 (or $6,500 if 50 or older), and can withdraw the money and earnings tax-free in retirement. You can contribute the full $5,500 as long as you have earned income and meet certain income limits and requirements. You can also contribute on behalf of a non-working spouse. An additional benefit of a Roth IRAs is its flexibility. If you end up needing the money before retirement, you can withdraw up to the amount you’ve contributed (not the growth) for any purpose without additional tax or penalty.

If you have young children, it may be a good idea to use your extra money to contribute to a 529 account. Like a retirement account, a 529 account is an investment account that grows tax-free and is used for qualified education expenses. As with any long-term goal, it pays to start early. You’ll be able to use the money tax-free for college bills, and depending on where you live you may even get a state income-tax deduction for your contribution.

If you don’t want to tie your money up for retirement or college, you can open a taxable brokerage account and invest for other long-term financial goals. Use the extra cash to buy shares in an appropriate mutual fund, but make sure your investment allocation is in line with your goal. If you’re investing to build up a down payment in the next few years, you can’t afford to take as much risk as you can in a retirement account that may have 10 or more years to grow.

If you have your financial bases covered, consider using your refund to make a charitable contribution to help others in need. You’ll feel good — and you’ll be rewarded for your good deed when you file your tax return next year (charitable contributions are deductible if you itemize). You also can use your refund to open a donor-advised fund. This is a kind of charitable investing account where your charitable dollars can grow over time. You can claim a tax deduction (if you itemize) in the year you make a contribution to the fund, and the money can grow over time until you decide which charities you’d like to support, or split your giving over multiple years.

There are many good uses for a tax refund. If you have debts or lack an adequate emergency fund, the answer is easy. If you’re down to your mortgage and have a comfortable savings account, then you have some options. Decide what does the most good to improve your financial well-being at this point in time. That answer will be unique to your family and your financial goals. And if your refund was substantial, consider giving yourself an immediate raise by adjusting your tax withholding to increase your monthly take-home pay.