About 75% of Americans will get a refund from the IRS this year, and if you expect to be among them, chances are you're already thinking about what to do with yours.
Before you run off and spend your tax refund on a vacation, new TV, or a shopping spree at the mall, consider using your refund (or at least the majority of it) to improve your future financial situation by either paying down debt or investing for your future. You might be surprised at the impact it can have.
Pay down your "bad" debts
If you have more credit card debt than you'd like, paying it off should be your No. 1 priority if you get a tax refund. This should take priority over saving money, investing, or splurging on something you don't really need.
For example, if you have $2,000 in credit card debt at 18.9% interest and make a minimum payment of $35 per month, it will take you 140 months to pay off the balance in full, or a little less than 12 years. So, to pay off your $2,000 in debt, you'll actually make $4,900 in payments to your credit card company. And that's assuming you don't charge anything new.
So by using your tax return to pay off your credit card debt, you're really getting a lot of value for your money. A one-time $2,000 investment would save almost $3,000 in interest over the long run. To see how paying off your credit cards can benefit you, enter your debt, interest rate, and monthly payment amount into this calculator from Bankrate.
Prepare for an emergency
According to a recent survey, 62% of Americans would be unable to cover a $500 emergency expense using the cash they have available in a checking or savings account. There's no reason to let this happen to you, especially if you're expecting a tax refund this year.
Many experts say you should ideally have six months' worth of expenses in a readily accessible emergency fund. You might be surprised at just how much money this can be. Consider your rent or mortgage, utilities, car payment, gas, groceries, and all of the other expenses you have throughout a typical month, and multiply it by six. If you have less than this amount in an accessible place, you should seriously consider using your tax refund to add to your safety net.
Even if you can't get to six months' worth of expenses, something is better than nothing. Do you really want to go into debt every time your car gets a flat tire or you need to pay a medical bill? An emergency fund is great insurance against those types of unexpected costs.
Save it for your future
If you're doing OK in the other two areas mentioned above (no high-interest debt and an emergency fund in the bank), the best bang for your buck is to invest your tax refund. However, only 8% of Americans do it, according to one study.
Let's say you're expecting a $2,000 refund this year. If you were to invest it and match the S&P 500's historical average rate of return (about 9.5% per year), your refund could grow to more than $12,000 in 20 years. If you invested $2,000 of your refund every year, you'd have nearly $110,000 in 20 years at that rate of return. After 30 years you'd have about $300,000.
|Years||Growth of $2,000 Per Year (compounded at 9.5% annually)|
In other words, by simply saving and investing your tax refund every year, you could be well on the way to a secure financial future and comfortable retirement.
It's OK to treat yourself a little
Now, I'm not saying you can't have some fun with your tax refund, but it shouldn't be your main priority. If you get a refund, by all means go out to a nice dinner or buy yourself something you've had your eye on. Do that, and then use the rest to better your financial situation. You'll be glad you did!
Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.