So you're getting an IRS refund -- maybe even a bigger one than you anticipated. The average refund this year is over $3,000, according to the IRS. That's the biggest chunk of money most of us will see at one time all year, at least that's not already earmarked for bills. What's the best use of your windfall?
The three basic things you can do with your refund are to save it, spend it, or use it to pay off debt.
Save it
You'll seldom go wrong by keeping the money and investing it. An average tax refund could be a great start to an investment account, or a boost if you've already started one.
Another great reason to save money is so it will be there if you need it. If you don't have an emergency fund, start one. Your emergency fund should be invested in something with low to moderate risk, in an account you can get to quickly if necessary.
Spend it
Spending your refund sounds like heresy for those who are trying to build up wealth. You'll never become financially independent if you spend every dollar you get.
Sometimes it's OK to spend your tax refund, however. If you've been wanting or needing to buy something, even a nonessential item like a flat-screen TV, it's far better to use your tax refund to buy it than to go into debt.
Sometimes spending money pays you back in the long run. You could make some smart weatherization improvements to your home, for example, and get an impressive return on your money. You'll feel less drafty next winter, too. Or you could invest in your small business, or in learning to be a better investor.
You may want to include giving money to charity in the spending category. You can't measure the returns on giving in dollars and cents. If charitable giving is part of your plan, using a windfall may be the easiest way to do it.
Pay off debt
If you have high-interest consumer debt, pay it off. If you're having too much income tax withheld while you pay 18% or higher interest expense on credit card debt, all the investing savvy you can get won't dig you out of that hole.
If you have more credit card and other consumer debt than you can pay off with your tax refund check, learn how to pay off your debt as quickly as possible. Getting and staying out of consumer debt may be the most important financial move you ever make.
Paying down your mortgage with your tax refund check is somewhat controversial. Your mortgage rate should be low these days, and it's tax deductible. Comparing just your rate of return by paying off your mortgage with other options, it's not likely to be your best choice.
Paying off your home mortgage may be one of your financial goals; for example, if you want to own your house free and clear before you retire, that's great. If you're looking for your best rate of return, you might want to keep looking.
One way to decide whether to pay off debt or to invest is to compare the interest rate on the debt to the rate of return you expect on your investments. That's not usually difficult with credit card debt. If you have a lower interest loan, such as a car loan, compare the interest rate on the loan with your average return on investments. Don't forget state and federal income taxes. Give paying off the loan a little edge for the fact that it's a guaranteed return. Very few investments are.
A balanced approach
If you're getting a significant refund, you may get the best use of your money by spreading it around between saving, spending, and paying off debt. Paying off debt may be the most important thing you can do with your refund, but if you wait until you're at zero debt before you start investing or you let yourself spend anything, you'll become frustrated.
Here's just one suggestion for what to do with a $3,000 refund:
- Take the first $1,000 and pay off credit card debt. If you have more than one credit card, focus on the card charging you the highest rate first.
- Put the next $1,000 into savings or an investment. There's something to be said for starting a savings habit now, even if you still have some debts. If you've never had a brokerage or other investment account, now's a great time to start one. As an added benefit, you can start investing and trading with smaller amounts of money. By the time you have your debts paid off and you're ready to make larger trades, you'll be a seasoned investor.
- Go ahead, take the last $1,000 and spend it. Depending on your situation, surely you can afford some kind of splurge to celebrate getting your refund. After all, you just paid off some debt and put money into your investment account. Maybe your splurge is a long weekend someplace fun, or if your refund is smaller, maybe it's a latte. It's easier to stay on a long-term savings and investing plan if you give yourself some kind of reward.
Your best plan depends on your situation and the amount of your tax refund.
What not to do
One of the worst things you could do with a tax refund is to use it to go further into non-mortgage debt.
Believe it or not, that's what some people do with a windfall. They head right down to the nearest pickup dealer and make a down payment on a $30,000 truck. It's called "how to go broke by getting money in the mail."
Plan ahead
Perhaps the most important thing you should do when you get a huge tax refund is to make sure it never happens again. Getting a huge tax refund every year is not smart. No matter how good an investor you think you are, you're not planning well if you leave thousands of dollars parked at the IRS all year, earning zero percent interest. Adjust your income tax withholding or estimated tax payments, and then keep closer tabs on your tax situation from now on. Keep your money working for you -- all year long.
