If you're getting a tax refund this spring courtesy of our pals at the IRS, then you're in good company. Each year, about 80% of filers are eligible for a refund, and last year the average refund hovered around the $3,000 mark.
Once that refund hits your bank account, your first thought may be something along the lines of "Shopping spree!"
Not so fast.
Let's not forget that the reason people get refunds in the first place is that they overpaid their taxes throughout the previous year. And while you may be inclined to view your refund as a financial gain, in reality, it's actually a loss of sorts -- because, had you gotten that money in your paychecks all along, you could have invested it instead of loaning it to the government in exchange for nothing.
So, now that you've reclaimed what's rightfully yours, here are four great ways to put that refund to use.
1. Build up your emergency savings
Before you save for anything else, you should set aside money for emergencies such as a job loss or an unexpected illness. The amount you'll need saved up depends on your individual circumstances; someone with children and a mortgage may require more backup cash than a single renter with no dependents. But for the most part, you should stash enough cash to cover at least three to six months' worth of living expenses. If you're due a refund and have yet to fully build your emergency fund, then take that check and stick it directly into a savings account.
Even if your emergency savings is fully funded, it never hurts to have a little extra in there. If you're a homeowner, for example, you never know when a pipe might burst or your roof might start to leak. Similarly, cars can suddenly break down, and major appliances can break. These things cost money -- and a lot of it. There's really no such thing as having too much cash set aside for a rainy day.
2. Pay off bad debt
There's a difference between good debt and bad debt. While a mortgage, for example, can be a net positive for your finances, credit card debt is almost always bad news. If you're carrying a balance on your credit card, then now's your chance to pay it off. Say you receive a $3,000 refund and happen to owe that much to your credit card company, which charges 14% interest for the privilege of paying that balance over time. If you use that $3,000 to knock out that balance in an instant, then you won't lose any more money to interest. On the other hand, if you use that money for something else and pay off that loan over the next 12 months, you'll wind up shelling out more than $200 in interest charges.
3. Lower your student loan balance
Americans owe roughly $1.2 trillion in student loans. If you're one of them, then consider using your tax refund to put a dent in your balance. The sooner you pay off those loans, the sooner you can move forward without the burden of monthly payments holding you back. And once you finally eliminate your student loans, you don't have to worry that a financial emergency will cause you to default on your debt and destroy your credit in the process. Let's say you owe $10,000 in student loans and have 10 years to pay them off at a 6% interest rate. Stick to the minimum monthly payment, and you'll wind up shelling out over $3,000 in interest over the course of a decade. Apply a $3,000 refund to your balance instead, and you'll knock several years off your loan and save a good $1,600 in interest.
4. Pad your retirement account
Whether you're decades away from retirement or within a few years of making your grand workforce exit, you should be contributing as much as possible to your 401(k) or IRA. And money invested now is more valuable than you may realize, because it will have the longest time to grow and compound. Say you're 30 years old, receive a $3,000 tax refund, and put that money into a retirement account that grows at an average rate of 8% per year (a reasonable assumption, as 8% is slightly below the stock market's average). By the time you reach 65, that $3,000 will have grown to -- get ready -- over $44,000.
And to think you had originally planned to spend it on a new TV.
Of course, if you're having trouble fighting the urge to spend that money on the things you don't need but technically deserve (because, in theory, we all work hard and deserve a little reward here and there), then designate a percentage of your refund as fun money, and use the rest responsibly. If you receive a $3,000 refund, you might give yourself 10% to spend on a new gadget, wardrobe, or fancy dinner, but use the rest in a way that will serve you better in the long run.
Remember: That tax refund is not free money. It's your money that got into someone else's hands along the way. Now that it's back where it belongs, be sure to make the most of it.
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.