Tax refunds are a bad thing in theory because when you get one, it means you gave the government an interest-free loan on that money and didn't collect it as you earned it. But most tax filers would much rather get money back from the IRS than owe during tax season, so if you have a large chunk of cash coming your way, you're probably, for the most part, pleased.
But before you make plans to blow that money, consider the different ways it could really help improve your financial picture. Here are a few things you can do to make the most of that so-called windfall.
1. Build yourself an emergency fund
Without emergency savings, you may have no choice but to resort to debt the next time an unplanned bill lands in your lap. Similarly, without cash reserves, you could land in dire financial straits if you're laid off at work and don't find another job for months. That's why you should aim to have at least three months of essential living expenses tucked away in the bank. If your current savings account balance falls short, you can use your refund to make up some, or all, of the difference.
2. Pay off expensive credit card debt
The longer you carry a credit card balance, the more it will cost you in interest. Not only that, but too much credit card debt can actually bring down your credit score, making it harder and more expensive to borrow money when you need to.
If you're sitting on credit card debt, your refund could be just the thing to either eliminate it or make a sizable dent in it. And having less debt could also help alleviate some of the stress that those with high balances tend to suffer from.
3. Save for your future
Seniors who attempt to live solely on Social Security often end up struggling financially. To avoid a similar fate, you must make an effort to build a nest egg while you're working. If you need a little boost to get started, your tax refund can serve that important purpose.
In fact, let's imagine you get $2,000 back from the IRS this year and you put that money directly into your 401(k) or IRA. If you then invest that money heavily in stocks so that your savings generate an average yearly 8% return, and then leave it alone for 35 years, it'll grow to almost $30,000 during that time. And while that's not enough money to retire on, think about what your savings balance might grow to if you were to invest your tax refund every year.
4. Fund an important purchase you've been putting off
Maybe your car is on its way out but you've been driving that clunker around town because you don't have the money for a down payment on a new one. Or maybe the laptop you use to generate side-hustle income is old and slow, and a new one could help you work more efficiently and boost your earnings. Using your tax refund for important purchases like these isn't wasteful; it's a smart investment, and one worth making.
Remember, a tax refund isn't free money; it's your money that you never collected as you earned it. Tempting as it may be to use that cash to take a vacation, upgrade some electronics, or go on a shopping spree, you're better off using it responsibly. And if that refund is really substantial, you may want to adjust your withholding for the current tax year to avoid a repeat scenario.
It may be nice to get a modest sum back from the IRS during tax time, but if you're getting a refund that's upwards of $5,000, you're giving up too much of your earnings upfront and need to make changes.