About 83% of this year's tax returns are resulting in refunds, and the average refund processed by the IRS so far has been $3,120. And, about 150 million tax returns are expected to be processed for the 2015 tax year. While this is based on preliminary data, this translates to almost 125 million tax refunds totaling more than $388 billion. If you're one of the millions expecting a nice refund this year, you might be wondering the best ways to put that money to work.
When it comes to spending a tax refund, everyone has different priorities and things they want to buy, but there are some needs we all have in common. With that in mind, here's how I would put my tax refund to work, in order of first priority to last.
1. Your health comes first
I've written before that adequate health insurance and other resources to take care of your family's health is the single most important factor in overall financial well-being. Why? Simply because without health insurance, you are one serious health problem away from financial ruin.
Now, whether you agree with the act itself or not, the Affordable Care Act has done a pretty job of making sure people aren't uninsured. However, there are millions of Americans with high-deductible health plans who could feel serious financial strain if they need unexpected medical care.
If you have excellent insurance with a deductible you can easily handle, skip this section. However, if you have a high-deductible health plan, defined as $1,300 (single)/$2,600 (family), with maximum out-of-pocket expenses of $6,550/$13,100, a Health Savings Account, or HSA, could be the best use of your tax refund.
A HSA is one of the best tax-advantaged account types you can find -- money you contribute is tax-deductible, growth is tax free (you can invest your HSA money), and withdrawals for qualified medical expenses are tax-free. And, unlike a Flexible Spending Account, you don't lose unused contributions -- your money will grow and compound. After age 65, you're free to withdraw the money for any reason, making it a great form of retirement savings as well. Here's an excellent in-depth look at HSAs by my Foolish colleague, Selena Maranjian.
2. Could you handle an emergency expense?
Most experts recommend that you should have six months' worth of expenses set aside in a readily accessible place, like a savings account. While this may be a little on the high end (I tend to suggest a three-month cushion), the reality is that most people aren't even close to being prepared for an emergency. In fact, a Federal Reserve report found that 47% of Americans couldn't handle a $400 unforeseen expense without borrowing the money or selling something.
The point is that investing and paying off debt isn't necessarily a good idea if you don't have any funds available for unexpected expenses. After all, what's the point of using extra cash to invest, only to have to withdraw it the next time your car breaks down?
So, after making sure you and your family's healthcare needs are met, the next best thing you can do with your tax refund is to start or add to your emergency fund. Even a few hundred dollars is better than nothing.
3. Do you have high-interest debt?
After healthcare and an emergency fund, the smartest way to use your tax refund is getting rid of high-interest debt, such as credit cards.
It just doesn't make good financial sense to invest if you have lingering credit card debt. Let's say that you get a $2,000 tax refund, and you have the choice of paying down credit card debt at 16% interest or contributing to your IRA. Well, at 16% interest, you're paying $320 per year just to maintain that debt. Even the best investors can't realistically hope to achieve annual returns of more than 10-12% on a consistent basis, so even the high end of this range implies investment returns of $240 per year. In other words, by investing the money and leaving your credit card debt alone, you're actually setting yourself up to lose money.
4. Have you maxed out your retirement accounts?
After these other aspects of your financial life are taken care of, only then does it make sense to start investing. If you haven't done so already, consider using your tax return to start or contribute to an IRA for 2016. This will allow you to save for your retirement while enjoying tax advantages such as not having to pay capital gains or dividend taxes annually. Further, if you contribute to a traditional IRA, you could qualify for a tax deduction on your next tax return, so here's a quick guide to help you decide which type of retirement account is right for you.
5. Treat yourself a little
Having said all of that, there's nothing wrong with using some of your tax refund to treat yourself. Go buy those new shoes you've had your eye on, or take the family out to a nice dinner. However, I strongly advise against treating your tax refund as "extra money." After all, your tax refund represents a part of your salary, and you should consider it as a paycheck. You wouldn't run out and spend your entire paycheck on a vacation or a shopping spree without taking care of your more practical obligations first, so why would you do that with your tax refund?