It is the time of the year when Americans file their taxes and hope to get some money back from the IRS. It’s the second year after the Trump administration’s tax reform that promised tax savings to millions of low and middle-class people. Frankly, it was not a big win for our family. Did you already finish the return and find yourself among the lucky folks who received a refund? Then you might be wondering now what the best ways to spend the tax refund money are?
(If you didn’t file the taxes yet, H&R block software offers cheaper than TurboTax option – check it out. You can start with a free trial, no obligations).
The truth is there is no one best way to use tax refund as everyone’s situation might be different. Some people are deep in credit card debt, some need to think about an upcoming retirement. There are so many financial needs in our lives that it’s really hard to prioritize between them.
To make this decision easier, I want to recommend the same principles that Dave Ramsey mentions in his famous book “The Total Money Makeover”, but with some additional personal touches. (By the way, it’s a really good book to start with if you are looking to improve your finances.)
You can guess that my idea of spending tax returns wisely doesn’t start with splurging on a luxury restaurant or designer clothes (however it does end almost there, keep reading).
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1. Start Or Grow Your Emergency Fund
The sad reality is that too many Americans will find it hard to come up with $1,000 in case of an emergency. Actually, the Federal Reserve survey has found that 40% of adults can’t cover even a $400 urgent expense. A broken car or an AC unit fix cost would be just put on a credit card, to add to already heavy debt burden. David Ramsey’s proposal is to establish the emergency fund of $1,000 as the first step to financial independence. Unfortunately, the prices kept rising since that book was written and now I would recommend at least doubling this amount.
If you don’t have $2,000 in cash or liquid account – this is one of the best uses of your tax refund money. You don’t have to keep the stash under your mattress. High yield saving account with fast and easy access can serve for this purpose and even make you some money (about 2.25% as of March 2019).
2. Urgent Investments In Your Health And Your House
If you live from paycheck to paycheck and don’t have an emergency fund, there might be something that you really need for a long time but couldn’t afford.
My dryer was making screeching noise for months, while I was hoping that in some miraculous way it would fix itself. It went from making the noise once in 15 minutes to once in 5 minutes but I didn’t lose hope, knowing how much it costs to call the professional in. I even convinced my husband to open the dryer and look inside. We did it, but paused, being terrified that we won’t be able to put it back together. The funny thing is that the noise stopped for a while after that (did we managed to scare the dryer?).
Long story short, we ended up paying $200 to a professional for replacing several parts. The dryer is back to life.
If you have an appliance, a car or an issue with your house that requires attention – just fix it and move on. The tax refund can be a great help in such a case.
Even more important, if you are delaying any medical or dental procedure or doctor visit because of the cost – use this IRS return to get it done. You are your most valuable asset. Please, never neglect your health, my friend.
3. Pay Credit Card Debts
Once you are all set with the emergency fund, check if you have any past due bills or credit card debts. There are many ways to start paying off the debt and using the tax refund is one of the less painful options.
Related post: How To Cut Credit Card Debt? 7 Easy Ways To Start Today
If you have many different debts and loans, you might want to consider debt consolidation and refinancing. I highly recommend a service called Credible for refinancing credit card and student loans. Everyone’s situation is different, but it’s worth to check out, as it’s possible to reduce the interest rate and monthly charges. Comparing prequalified refinancing rates with Credible only takes a few minutes and wouldn’t affect your credit score. They guarantee the best rate for you. If you find a better rate elsewhere, Credible will give you $200.
Once you did your best with debt consolidation, pay off the most urgent bills, the credit card balance with the highest interest rate or just reduce the balance of the new loan.
4. Make a 401k Contribution
If you are free from credit card debt and student loans (congratulations!), the next few steps offer you the best ways to invest your tax refund.
First of all, I recommend you to take a holistic look at all your finances and retirement plans. My favorite free software that allows tracking of all your financial accounts and net worth in the same place is Personal Capital (check out my full Personal Capital Review here). You will be able to evaluate your path to retirement and decide if you need to invest more in your future financial comfort.
If your employer offers a match to your 401k or equivalents contributions, it will be the best and almost unbelievable way to make a 100% risk-free return of your additional contribution.
For example, if the employer matches up to 3% of your $50,000 salary, then you’ll get an additional $1,500 for the first $1,500 you put into the 401k plan.
Actually, you should always maximize employers matching of 401k, meaning make every effort to put these first $1,500 in. Of course, it’s also tax-free money and will reduce your next year tax liability.
5. Maximize Health Savings Account (HSA) Contribution
If you are already at a maximum with your 401k matched contribution, the next best way to save is a bit unexpected – the HSA!
Not all employers offer this type of health insurance as it usually means higher monthly payments. However, if you have and use this option, consider maximizing the HSA, as it’s tax-free money not only now, but also AFTER retirement if used on qualified medical expenses (after retirement you can use it for anything else as well but then it will be taxed, same as 401k).
Do you know many retired people that don’t have any medical expenses? I don’t.
The HSA doesn’t expire if not used in the same tax year, like the FSA (Flexible Spending Account), and remains yours when you leave the employer or retire.
6. Make An IRA Contribution
Next option is to consider investment in the IRA (an Individual Retirement Account). Before doing this, check with your accountant (or at least online) if you are eligible for any tax benefits and how much you can contribute. If you maxed out your 401k plan, you might not be eligible for additional tax-free contributions.
7. Invest For Long Term
If you are set with the maximum allowed tax-free retirement savings, you still might need more savings to achieve your personal retirement goals (again, it’s easy to check with Personal Capital free software).
Being a financial professional myself, in my everyday reality, I don’t have the time for monitoring financial markets and analyzing every possible investment. The majority of people don’t have the skills to do it and are not really willing to learn and that’s ok. As long as you understand the basic idea of compound interest and the time value of money, you know that the best way to grow wealth is consistent long term investment in financial markets.
The easiest way to do it (really set it and forget it) is with a robo-advisor app, like Acorns that takes care of building the right investment portfolio for you. For example, with Acorns you can save and invest the round-ups of your credit card transactions, set up weekly or monthly contributions or invest one-time amount from your tax return money. By the way, Acorns has IRA accounts as well.
8. Save For Your Children’s College
As a parent, I have to think about the upcoming education costs for my three kids (not that their current elementary school is cheap…). I’m not planning to pay in full (well, I just can’t afford it) for their college, but I’d like to help a bit, while I hope that they will find some creative ways to come up with the rest of the tuition and cost of living.
You know, it’s never too early to start a college fund, so even if your baby is still in diapers, you can open a 529 fund and let the money grow tax-free! Some states, like NY, even give you a tax credit for doing this.
9. Make An Additional Mortgage Payment
If you are on the right path to retirement and have enough money in your 401k, IRA and other investment accounts, you can consider making an additional payment of your mortgage.
Living in the house without a mortgage gives a better feeling of financial security, so I totally can relate to the desire to reduce the mortgage balance.
However, before making this payment, check out the balance and the interest rate. If your balance is relatively low (less than 50% of the house value) and the interest rate is low (compare to the high-yield saving accounts that pay about 2.25% as of March 2019 and to the average financial markets return of about 7.5% in the long term) – maybe investing the money is a better option?
On the other hand, having a high balance and interest rate creates a big risk for your family that you might want to reduce.
10. How About A Little Splurge For Yourself?
I still like the advice I’ve got a long time ago when I tried to make money from daily trading with stocks. I was not successful at it, but I remember the advice. It says – take 10% of the profit and get something nice for yourself – a vacation, a new handbag, spoiling massage or a new car, depends on the size of that profit. Put the rest into work by investing it again. The reason behind this is that we need to FEEL our success, that it makes a difference in our LIFE, not only in the number of dollars in our bank account.
I like to apply this rule to any unexpected money I get. However, the tax return is a different story. If you get the check from the IRS now, it means you didn’t plan your taxes right and actually gave an interest-free loan to the government. Now they returned your money back. It’s not similar to winning the lottery and getting a prize. The tax return was YOUR own money from the beginning.
The good thing about it is that somehow, for better or worse, easily or by struggling, you have survived the year without this money. Maybe it cost you depriving yourself of these small splurges, but you did it. So why not have some fun now? Sometimes a little cheer up is all we need to refill our energy and continue moving in the right direction.
The bottom line is that if there are no acute emergencies, you can consider spending a portion of your tax refund on yourself, on a little something that makes you smile.
Plan Your Next Year Taxes
Before I close, another important thing to do is to analyze the reason why did you get this tax refund, especially if the sum is quite big related to your income.
Why did you overpay taxes and helped the government to finance itself without paying you an interest?
- Check if you can update your W-4 form and claim more dependents to reduce the tax deductions from your paychecks.
- Did you add any voluntary state tax deductions that turned out unnecessary?
Leave me a comment and tell me what you did you do with your tax refund money?
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