As of March 20, 83% of Americans who have filed their 2014 taxes have received a refund this tax season, with the average amount reclaimed from Uncle Sam coming to $2,900. That's a nice chunk of change, and there are a lot of different ways to put that money to work. So what should you do with your refund if you're among the majority of Americans receiving one?
We asked our Motley Fool experts what they think is the smartest thing taxpayers can do with their refund. Read on for their answers.
One of the best ways to use your tax refund -- even better than investing it -- is to pay off any high-interest debt, such as credit card debt. Even if your investments perform relatively well, credit card debt can be costly enough to more than cancel out your gains.
Let's say you're carrying $5,000 in credit card debt at an interest rate of 17%. If you end up with an extra $5,000 and decide to invest it, what kind of returns can you reasonably expect to earn? Perhaps 10% if you make good choices. Let's even say you're an extremely skilled investor and can produce annual returns of 12% from your investments. At that rate, your $5,000 investment would return about $600 in a year.
However, because you still have that credit card debt, you'll pay $850 in interest just for the privilege of owing the credit card company money. So, in this case, even with outstanding investment performance, you finish the year with $250 less than you would have if you simply paid off the debt.
In a nutshell, paying off credit card debt should be your top financial priority after taking care of your basic living expenses.
I agree with Matt that the smartest thing you can do with your refund is to pay off high-interest debt. The second-smartest thing you can do is to put it in an emergency fund if you do not already have one built up.
The general rule of thumb is that you should have a cash emergency fund that covers at least six months' worth of living expenses. This helps to protect you in the event of a job loss, health problems, or some other calamity.
Unfortunately, over 60% of Americans don't have that much saved up.
A 2014 Bankrate.com survey found that 40% of respondents had savings that only covered three months of living expenses, while another 25% had no emergency savings at all. Young people, defined as those aged 18 to 30, were most likely to have five months of savings, while those aged 30 to 49 were most likely to have no emergency fund.
The situation might be worse than it appears, as a few years ago the National Bureau of Economic Research found that 25% of households couldn't come up with $2,000 in 30 days, while another 19% could only do so by selling possessions or taking payday loans. This is a not a good position to be in.
If you have paid off your debt and don't have an emergency fund, your tax refund check is a great way to start one.
For many people, a tax refund is the biggest lump sum of cash they're likely to see all year. That's what makes it a great opportunity to start saving for retirement by opening an IRA. In many cases, opting for the Roth version of the popular retirement account can be a smart way to get even more tax savings.
A Roth IRA is generally the better choice when you're in a lower tax bracket now than you expect to be in after you retire, because Roth IRAs are tax-free when you take withdrawals in retirement. A traditional IRA will pay off better if you're in a higher tax bracket now, as you'll get an up-front tax deduction but have to pay taxes when you take money out of the account.
If you hurry, you can actually use your refund to make an IRA contribution for 2014; if you use a traditional IRA, it can even allow you to claim a larger refund this year. With the April 15 deadline approaching, you have to be careful using this strategy. But even if you don't make it in time, getting an early start on your 2015 IRA contribution is still a smart move for your financial future.
Getting a tax refund is nice, but unless your income can vary significantly from year to year, that refund is actually an indicator of poor tax planning. Hear me out: A tax refund is just that -- a refund of money the government owes you because too much was held from your payroll.
If your tax situation is relatively stable, it's a good idea to fill out a new Form W-4 with your employer and change your withholding allowance. Sure, you won't get a return at the end of the year, but you'll get more take-home pay every pay period.
The best part is that you can put that money to work immediately, rather than having to wait for tax time to pay off debt, build up savings, or fund your IRA. With today's direct deposit, automatic investment, and scheduled online bill pay, you can even have everything happen automatically on or near payday if you're afraid you'll blow the money before you put it to work.
It's your money. Get it as soon as you can, and put it to work quickly.
Dan Caplinger has no position in any stocks mentioned. Dan Dzombak has no position in any stocks mentioned. Jason Hall has no position in any stocks mentioned. 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.