5 Ways to Make your Tax Refund Work for You
If you’re lucky enough to get a tax refund, how you use it is important. While it might feel like ‘free money,’ it’s money you gave up throughout the year and overpaid to the IRS. So using the funds appropriately after receiving your tax refund is important to help you reach your financial goals.Ideally, your taxes will come out as close to neutral as possible – you will not owe or receive much – to maximize your monthly cash flow. If the amount owed or due is greatly off then you should review your tax withholding to determine what may have cause this issue. If you did receive a tax refund for 2022, here are five ways to make your tax refund work for you.
Pay Down High-Interest Debt
If you have high-interest consumer debt, one of the best uses of your tax refund is to pay it down or off completely, if possible. Debts with an APR of 10% or higher exceeds any annual returns you’d likely receive on investments, based on historical average returns. While it might feel like you aren’t reaching your financial goals by using your tax refund to pay off debt, you are actually giving yourself a larger return on your money. If you let high-interest debt remain unpaid, you’ll spend more on interest while the debt is outstanding. If you want to use only a part of your tax refund for high-interest debt, take inventory of your outstanding debts, focusing on those with the highest interest rates first to generate the biggest cost savings.
Increase your Emergency Fund
Everyone needs an emergency fund with three to six months of expenses. This is foundational to prudent financial planning. An emergency fund is there to help you in times of ‘emergency.’ This may look different for everyone, but a few common reasons to use an emergency fund include:
• Job loss
• Injury or illness
• House crises (broken water heater, HVAC systems, water damage, etc.)
• Car issues (mechanical issues, accidents, etc.)
If you have an emergency fund created, consider adding to it, even if you have a fund set aside. If the pandemic, and more recently the mass layoffs are some of the largest companies, have taught us anything it’s that we should be prepared for the unexpected, so the more money you have, the better.
Increase your Investment Savings
Assuming your debts and emergency fund are in great shape, another great use of your tax refund is to increase your investment portfolios. There are many ways to do this and the best option is dependent on your situation and financial needs. If you have enough, you can split your funds between your various investments or choose one area to focus on.
Here are the top areas to consider:
It’s always a good idea to invest more money for your retirement. If you don’t have an IRA yet, this is a great time to open one. As a bonus, you may get a tax deduction for your contribution depending on the type of account you save in. Each year there are limits to how much you can contribute. For example, in 2023, the limit is $6,500 if you’re under 50 and $7,500 if you’re over 50. The more money you have saved for retirement, the better. Keep in mind that inflation will affect your buying power during retirement, so not only is saving important, but also having your money working for you by being invested.
You can also use some of your tax refund to invest in your brokerage accounts. These accounts don’t have limits and also don’t have the same withdrawal requirements, meaning you can use the funds however you want.
Taxable investments include assets such as:
• Mutual funds
• Real estate
529 College Savings Plan
529 plans are tax-advantaged college savings plans. Some states offer plans that offer tax deductions in the year you contribute. Even if your plan doesn’t offer tax deductions, the money you contribute grows tax-free. In addition, if you use the funds for eligible educational expenses, the withdrawals of the contributions and earnings are also tax-free. If savings for your child’s education is important then consider a 529 college savings plan.
HSA – Health Savings Account
HSA or Health Savings Accounts are triple tax-advantaged accounts to use for medical expenses. You can use HSA funds the year you contribute or roll them over for future use. Many people use the funds to save for medical expenses during retirement. The maximum contribution for individuals in 2023 is $3,850; for families, it’s $7,750. An added benefit is that any unused funds can be used for whatever you want without penalty after age 65. Meaning HSA’s can act not only as a medical savings vehicle, but also boost your retirement savings.
Save for Short-Term Goals
If you have short-term goals you need more funds for, your tax refund can be a great way to reach your financial goals. Short-term goals are those you want to achieve in around the next five years. Some common examples include the following:
Saving for a down payment on a house is a great use of your tax refund. Not only does the money help you buy a house to live in, but it puts the money into an asset that will also ideally appreciate over time. Putting down 20% or more on a home purchase will eliminate the added costs of PMI – Private Mortgage Insurance, but many loan programs allow you to put down as little as 3% – 5%.
Buying a car isn’t an investment in your net worth, but everyone needs one. The best case scenario is paying cash for a car, avoiding any interest costs, as this keeps your costs down. If you can’t pay cash for the entire car, the more you put down on it, the better terms you’ll get on a car loan, saving you more money.
While improving your financial situation and investing for your future is important, it is also important to enjoy today…within reason. There is nothing wrong with spending some of your refund on yourself – you did work for the money after all. Just limit the amount you spend to no more than 25% of your refund. This offers the best of both worlds; you can use some money for yourself, and invest the rest, investing in your future and growing your net worth.
How you use your tax refund can have significant financial implications. Spending some money on yourself is okay, but be sure to apply the remaining funds to important financial goals, starting with your high-interest consumer debt. If you don’t have debt, or it’s minimized, consider investing in other areas of your life, including retirement, your brokerage accounts, real estate, and using the money to fund short-term needs. The key is to make the funds grow for you, helping you reach your financial goals faster than you thought possible. Don’t forget that if you received a large refund that means you are overpaying in taxes throughout the year and need to evaluate what adjustments should be made to your withholding.