Now that tax season is upon us, many of us will be getting tax refunds. Getting a tax refund is great, but it can easily be wasted. There is a huge temptation to spend it all as soon as you get it. It's free money, right? This isn't really the case and we will get into why.
It can feel incredibly nice to get hundreds or thousands of dollars that you didn't have before. Why not splurge on something you might not get otherwise? This is completely normal and I normally try to splurge on something small. Then I use a decision framework for figuring out what to do with the rest of my refund.
If you are curious about this year's tax refund and standard deduction, checkout our other post. It can help you figure out how your taxes might change this year. For most people, it looks like we might be getting back more than before!
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As I said before, a tax refund often feels like "free" money. It was money I wasn't expecting as it had already been taken out for taxes. In reality, you should be treating your tax refund more like regular income.
The reason for this is that a tax refund effectively means you overpaid on taxes this year. The number of allowances on your W2 only gives a rough estimate for how much taxes to take out. Many times this rough estimate means that slightly more is getting taken out of your paycheck than needed. In theory you want to be as close to $0 as possible on your tax return. That means you were getting the maximum amount from your paychecks throughout the year.
It isn't like the government is "stealing", it's more that taxes are really hard to estimate when projecting out 12 months. Erring on the side of taking out a bit more isn't a bad thing, otherwise you would owe at the end of the year.
I like to think of my tax refund like a deferred paycheck. It's money I'm "entitled" to, but I'm getting it later to make sure I paid enough in taxes. Because it's a paycheck, I try to treat it as such. Meaning I'll put it in investment accounts, savings, etc. similar to how I would use any other paycheck. The only difference is I'll buy a treat that I might not otherwise. A fancy dinner, expensive concert tickets, etc. are a great idea. Enough to feel like a splurge, but won't waste your entire return.
Here are a few ideas I have for putting your tax return to work for you. I follow the wealth ladder system and use it as my framework for trying to figure out what to do with my tax refund.
If you are holding any high interest debt like credit cards, car loan, etc. this is a great time to pay a chunk of it off. You can save thousands in interest by paying extra on your loans.
Let's say you get back $1,200 from your return and currently have $5,000 in credit card debt that you pay $100 a month towards. If you were to keep making your regular payments, here is how long it will take you to pay back.
Starting amount: $5,000 | Paying per month: $100 | APR: 15.3%
Months to pay off debt: 81 | Total Interest paid: $3,009.3
If you were to pay off a $1,200 chunk right now, then keep paying $100 here is the difference.
Starting amount: $3,800 | Paying per month: $100 | APR: 15.3%
Months to pay off debt: 53 | Total Interest paid: $1,430.17
Paying off the $1,200 saves you over 2 years and $1,500+ of interest on your debt. This is a huge difference and is worth trying to knock out a chunk of your debt with your tax return. If you are trying to pay down debt, definitely look into leveraging your return to help you build your path to being debt free.
If you don't have an emergency fund, I would definitely suggest using your tax refund towards starting one. Depending on your risk tolerance, your emergency fund should be anywhere from 3-6 months of your monthly expenses. If you already have one, it can be a good idea to contribute a bit more to give yourself some leeway for any unforeseen expenses.
I like to pad my emergency fund a bit with my tax refund based on how much I am getting back. If you're emergency fund is already "full" consider putting 10-20% of your refund into it. Something always comes up throughout the year. It feels nice not having to touch your original fund amount while still being able to take care of unforeseen items.
If your finances are already in order you could consider investing your tax refund. Remember this is post-tax money so you have some flexibility with it. You can put it in your own post-tax investment account or find somewhere else to park it.
I personally love the idea of funding a Roth IRA with your refund. Because it is post tax you can put it into your Roth. If you do it before April 15th, it counts as last years contribution as well. This means you can get your tax refund, and still try and max your Roth for the year you just filed taxes for.
There are some goals you want to save for long term. Some of these could be considered a "splurge", but are still great to save for if you are planning on buying them anyways. Here are some examples:
All of these can often cost thousands of dollars. Getting a head start and saving for something in the future is never a bad thing. It's definitely better than going into debt for something. Start your fund now and save for your future goals.
If you find yourself not knowing what to do with a hefty tax return, take a look at our examples above. Getting a tax return can be great and can pay dividends in the future. Invest in your future self and put that return to work for you.