Well, April 18 has finally arrived, which means that we should all have our taxes filed, signed, and sealed by midnight tonight (unless, of course, you’ve filed for an extension). Whew! What a relief to have that done, right?
While there’s quite a bit to be said for adjusting your withholdings to avoid a tax return altogether (goodbye to the government’s 0% interest loan on your money each year!), many folks are grinning ear-to-ear as they eagerly await that direct deposit in their checking accounts. So, what should they do with all that money?
This wouldn’t be a personal finance website if we didn’t at least encourage you to think very carefully about your plans for that windfall. With the average American receiving about $3,000 back from the IRS each year, there are a number of options for your tax season cash boost. Plus, it’s not like it’s “bonus money” anyway… that cash was yours all along. The government has just been holding onto it all year – interest-free, of course – so you should really make the best possible use of it now.
Here are a few of our favorite ideas, and reasons why you should choose one of them before going on a shopping spree or buying a new car:
Build (or boost) your emergency fund
Another statistic for you: more than half of Americans don’t have enough cash on hand to cover an unexpected $500 expense. A whopping 63% of them said that they would have to take out a loan, charge to credit cards, or significantly cut back on spending if their car broke down or the dryer went kaput.
What does this really mean? Not only does it say that most Americans are only one broken arm or blown transmission away from digging a debt hole, but it is clear that less than half have a solid emergency fund.
Taking your IRS refund check and putting it into a high-yield savings account is one of the smartest things you can do. Aim first at tucking away $1,000 for emergencies. If you can save more, do it… but try to get at least a grand in that account, in case of the unexpected. Then, only dip into it when something is a true emergency!
Save up a few months’ expenses
Once you have that emergency account funded, it’s time to think a bit bigger. In case of a really big circumstance – such as losing your job or getting ill – you’ll want to save up a few months of expenses. The end goal is to have between three and six months’ worth saved up, which will give you a nice buffer in case of the truly unexpected.
If you already have an emergency fund in place, it’s time to start thinking about funding this account.
Learn More: Where to Put Your Emergency Fund
Pay off credit card or student loan debt
Debt-free. It’s something we all should strive for but many Americans can’t comprehend. Considering that the average household carries over $16,000 in credit card debt alone, it’s easy to see why the black cloud of debt hangs so thick. There is a way out, and it starts with a single dollar (or IRS refund check, as the case may be).
The average private student loan balance carried with it an interest rate between 9-12%. Credit cards are considerably higher, with an average of 16.2%. Throw in a late payment or two, and these rates can shoot up closer to 30%.
If you were to put your tax return to good use and pay off a credit card with an average 16% APR, you would not only be improving your credit score, building your net worth, and working toward a debt-free life…. You would essentially be “earning” a 16% return on that cash this year versus letting it sit in your checking account. And that’s one guaranteed investment that you should definitely jump on.
Fund your IRA or 401(k)
If you don’t have any high-interest debt and have a solid emergency fund, it’s time to start looking at retirement options for your IRS refund.
No matter how much you think you need to save for your latter years, taking full advantage of your retirement accounts is a smart move. Traditional IRAs and 401(k)s are tax-advantaged, meaning that as long as you stay within your annual contribution limits, these pre-tax dollars will work for you now. Your Roth IRA, on the other hand (assuming your income qualifies), will work for you later, especially if you are in a higher tax bracket further down the line.
Take that tax return, and use the extra cash to increase your work-sponsored 401(k) – especially if you have an employer match – or IRA contributions. Or, do what I did: front-load your Roth IRA, up to the $5,500 maximum, and don’t worry about it for the rest of the year.
Only go the investment route if you’ve already taken care of your debt priorities, have an emergency cushion in place, and are on track to max out your retirement accounts for the year. But if those are in place, look into investing that windfall.
Regardless of your asset allocation, you can generally plan to earn around 7% on your investment each year. (Of course, this varies greatly, but that’s a general rule of thumb.) This means that if you take your $3,000 average tax return and invest it, you could expect to end up with about $3,200 come next tax season.
Of course, investments have varying degrees of risk and return involved. You could wind up with a 0.25% return or a 40% return this year… that’s the name of the game. However, adding to your portfolio when you can is a great idea, especially if you’re in for the long game.
Pay down your mortgage
One of the more important ideas for a successful retirement is the elimination of your monthly mortgage payment. This not only builds your net worth with a substantial asset, but it also minimizes your monthly expenses and allows for a home equity line of credit, which can be called upon if ever needed.
Use your tax return to make an extra mortgage payment this year, and every year thereafter, and and watch the principal dwindle. For example: on a $200,000 home with a 30-year fixed mortgage at 5%, you are paying $186,512 in interest over the life of the loan. Well, that’s if you’re making 12 monthly payments a year.
Take your IRS check, and use it to pay a 13th payment each year, then watch the interest tower crumble. Imagine that you make just one extra monthly payment every 12 months on that same mortgage loan. You’ll instead pay off the home in only 26 years and you’ll only be paying $153,813 in interest over the life of the loan. That’s a substantial savings of $32,699!
What could you do with an extra $33k in retirement?
Contribute to the kids’ education fund
College isn’t cheap, and student loans aren’t something most of us want to see our children struggle with. If you’re able to set money aside now for your kids’ future education expenses, you’ll be grateful down the line.
Whether putting the cash in a 529 account or starting an IRA, you are able to save up cash tax-free. Not only does this save you as much as 35% (depending on your tax bracket), but it will also grow and earn interest over the years. Plus, of course, you won’t be hit with a tuition bill tens of thousands of dollars high. When your high schooler comes home with applications to a private university, you’ll be thankful you thought ahead.
Schedule a consultation with a CPA
Do you feel like you’re in a good place with your finances? Maybe you don’t have children and your home is paid off – where would your money be best served?
Take part of that tax return and put it to good use by scheduling a consultation with a financial advisor. They can take an objective look at your money situation and let you know exactly where you stand, as well as whether you’re on the right track to financial freedom. They will have suggestions as to where you should focus your efforts first, especially if you are aiming for a higher goal, like early retirement.
Donate to charity
Tax return time is a great opportunity to give back to your community through causes you support. You could donate canned goods to your local food bank, take bags of kibble to an animal shelter, clear out the closet for Goodwill, or add a little extra to your church tithe. No matter where your heart and passions lie, having a tax refund boost can allow you to do a little more without feeling the usual pinch.
Be sure to save your receipts on charitable contributions, too, for when next tax season comes along!
How will you be putting your tax return to work this year? Let us know how smart you’re being with your money below.