What to Do with Your Tax Refund
A tax refund is an influx of cash resulting from an overpayment of taxes to the Internal Revenue Service (IRS) or another taxation authority. Getting a tax refund can provide a big boost to your finances, but it’s important to manage the money in a smart way, such as with the methods described below.
Boost Your Emergency Fund
Having an emergency fund is a crucial component of a strong personal finance plan. An emergency fund helps provide a buffer so that you can get through any financial difficulties in life, which can be inevitable and also unexpected. You should aim to set aside enough money to pay your expenses for at least three to six months, depending on your tolerance for risk and your ability to save.
If you’re just starting to build an emergency fund, saving enough to cover three to six months’ worth of expenditures may seem like an unattainable goal, especially if your budget is already tight. Fortunately, getting some money back after filing your taxes can provide a big boost to your savings effort if you earmark your tax refund specifically for this purpose.
Pay Off Problematic Debt
Debt is neither inherently good nor bad. It’s merely a tool, or a means to an end. When debt is used in a smart way, such as with financing the purchase of a modest home, debt can be highly beneficial. However, when debt is used irresponsibly, it can be disastrous, both financially and emotionally.
Debt becomes problematic when it’s used to buy things you can’t afford. Usually, this type of spending leads to excessive credit card obligations, personal loans and other costly forms of credit. The resulting interest charges can quickly bust your budget and push you into a downward spiral.
If you get a tax refund and feel good about the state of your emergency fund, use your refund to pay down your credit card debt or other high-interest loans.
Increase Your Contributions to a 401(k) or 403(b)
If you’re fortunate enough to be free of high-interest debt, a great way to use your tax refund is to increase your contributions to an employer-sponsored 401(k) plan or 403(b) plan. This is an especially wise move if you are not currently taking full advantage of your employer’s match offering.
When considering the amount of retirement contributions that your employer will match, you should never leave so-called free money on the table. Do everything you can to reach the full match, which is specific to your employer and subject to change. A common employer match offering is as follows:
50% of contributions up to 6% of the employee’s eligible compensation
The sample terms stated above would allow you to get a 3% match from your employer each year — as long as you contribute 6% of your earnings to the plan. For someone making $75,000 per year, this amounts to $2,250 that you could receive as matching contributions from your employer ($75,000 × 3% = $2,250).
If you’re having trouble contributing enough to get the full match, your tax refund could help make up the difference.
Fund an Individual Retirement Account (IRA)
If your employer doesn’t offer a retirement plan, you can still use your tax refund to save in a tax-advantaged manner by contributing to an individual retirement account (IRA). You have two types of accounts to choose from: a traditional IRA or a Roth IRA. A traditional IRA involves a contribution of your pre-tax earnings, the potential for a tax deduction and tax-deferred growth. A Roth IRA involves a contribution of after-tax earnings and the potential for tax-exempt growth. The maximum you can contribute to any type of IRA each year is $6,000 per person (or $7,000 if you’re 50 or older), but this amount can change based on your income.
Buy Something That Saves Time and Money
Making long-term financial investments isn’t always the best use of your tax refund. Often, it makes sense to invest the money for the short term — in a way that saves you time or money.
For example, assume you are renting a home or apartment that doesn’t include a washer and dryer, so you are renting both appliances. It could make better financial sense to buy these appliances rather than renting them. A tax refund could help facilitate the purchase, and the long-term savings could be substantial.
Invest in Yourself
A final way to make good use of your tax return is by looking toward the future and investing in yourself, whether it be via a college education, a professional certification, a trade school or some other form of specialized training.
Depending on your situation, an enhanced educational foundation could allow you to advance your existing career or blaze a new and exciting path. Given the right circumstances, this is bound to elevate your job satisfaction and power your long-term earnings potential.
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- Internal Revenue Service. (2022, February 18). 401(k) Plans. Retrieved from https://www.irs.gov/retirement-plans/401k-plans
- Internal Revenue Service. (2021, December 20). Filing Season Statistics for Week Ending December 3, 2021. Retrieved from https://www.irs.gov/newsroom/filing-season-statistics-for-week-ending-december-3-2021
- Internal Revenue Service. (2022, February 18). IRC 403(b) Tax-Sheltered Annuity Plans. Retrieved from https://www.irs.gov/retirement-plans/irc-403b-tax-sheltered-annuity-plans
- Internal Revenue Service. (2021, November 5). Traditional and Roth IRAs. Retrieved from https://www.irs.gov/retirement-plans/traditional-and-roth-iras