A tax refund is something of an annual windfall in many households, and the tendency is often to spend it on long delayed purchases. While spending it immediately can be beneficial, it’s important to consider the options that are available and to realize that some are better than others.
Since tax refunds are so common, it’s easy to lose sight of the greater potential that they offer. They’re really mini-windfalls, a kind of forced savings plan. For many, they can be the only form of cash accumulation they have. That makes them a financial resource and as such, what you do with it should be carefully considered.
What are the options? I was able to come up with five.
Setting up and emergency fund: not having one is a true emergency
A major reason why many people don’t have an emergency fund—or any savings at all—is because making deposits from paychecks can be a painfully slow process. It’s often only after a long series of small deposits that a savings balance begins to become credible. But the arrival of a tax refund is a way to jump-start the process.
Once you have a substantial account balance, a basic nest egg, adding those small payroll deposits will begin to make a real difference, enough perhaps to convert even a spendthrift into a saver. The tax refund windfall is an opportunity to make this happen.
If you don’t have an emergency fund, then setting one up using your tax refund should be a priority. Operating without an emergency fund is truly playing with fire. Sooner or later there will be an income disruption or unexpected expense that will make this point only too obvious.
Padding your savings account: putting off spending for another day
Let’s say you already have savings, but you’re not sure exactly what it is you want to do with the refund. Maybe you have several ideas and can’t decide which way to go. Try this: you don’t have to do anything, at least not right away. You can just put the money in the bank, and by doing so you’re buying yourself time and keeping your options open.
Often, when people spend a windfall immediately they end up regretting what they did shortly afterwards. By taking your time, you might come up with more thoughtful uses for the money that you’ll feel better about in the long run.
Paying off debt: the gift that keeps giving
Paying off a debt is one of the very best uses of a tax refund. By paying off a credit card or installment loan, you lower your expenses and reap the benefits for years. Debt is an expense, a reduction in cash flow, and you can use this one time windfall to make some it go away.
Once a debt is paid, you have one less payment—a kind of perpetual monthly windfall, if only a small one. And just as important, paying off debt begins with one loan at a time. If you can pay off just one debt, you’ll be set up to payoff more. The missing payment from the debt you paid off will help make that happen!
Paying down a debt: the partial solution
You decide that you want to use your refund to pay debt but there won’t be enough money to completely pay off any one loan that you have—what do you do? For many people, this situation will prevent them from paying any debt at all. After all, if you can’t make a debt go way completely, what’s the point?
But a partial payoff can help and it can do it in one of two ways:
- By paying down a credit card balance, you immediately lower the monthly payment, which will produce an immediate benefit, or
- By paying down an installment loan, you will shorten the term of the loan. The benefit comes eventually, even if it isn’t immediate.
No, paying down a loan isn’t as clean or beneficial as paying it off completely, but that doesn’t mean it isn’t worth doing. Either way, the benefits will be ongoing.
Funding a retirement plan: going for delayed gratification
Probably the best option you can take, because you’re creating future wealth. Not only does it build more money for the future but does so on a tax deferred basis. And the refund you contribute to a tax sheltered retirement plan this year may be a deduction when you file your taxes next year, making future refunds even bigger.
Consider the long term potential of this strategy. If you decided to invest your tax refund in a tax sheltered retirement plan each year for 30 years, with an average tax refund of $2500 per year, you’d have $75,000—plus the income you earn on it—sitting in the plan at the end of the term. It may not seem like all that much in any given year, but after 30 years it starts to look like kind of money that can make a real difference in your life!
The best solution: thinking long term
What ever you decide to do with your refund—and obviously there are several options—make sure that it will provide benefits into the future. Whether you do that by paying off or paying down debt, saving for a rainy day, or investing money for the future, a tax refund is a resource that can make a difference if used wisely.
The option you choose will depend on personal circumstances, and you need to do what will provide the best benefit. The important thing is knowing what your options are before going forward.
What do you usually do with your tax refunds? Are there any options that aren’t listed here?
This post is from FiscalGeek staff writer: Kevin Mercadante. I’m very excited to have him contributing to the site. You can find out more about him at his own blog OutOfYourRut.com.