09/17/2020

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4 Ways to Spend Your Tax Refund (That Actually Pay You Back)



April 15th is a few weeks away; have you filed your tax return yet?

If the answer is yes, you’re not alone.  The IRS reported last week that it has already received about a third of the individual tax returns that it expects to process this year.  They’ve also issued more than 40 million refunds so far, at an average amount of $3155.

Investing your tax return instead of spending it

If you’re one of the happy refundees, that money may be burning a hole in your bank account as we speak.  Before you squander it on something you won’t remember by tax time next year, consider using it for something that can actually help you save or even earn money in the long run.  Here are four ideas:

Pay down credit cards

Credit cards tend to charge higher interest rates than other kinds of debt, which means that carrying a balance on them can cost you dearly.  Let’s say you have a $3000 balance on a credit card with a 13% APR (the average for a fixed rate card), and you’re paying $75/month toward it (a little more than the minimum). It would take you four years and four months to pay off the card, over which time you would spend $953.50 on interest.   Alternatively, you could nip it in the bud with your tax refund and spend that $900 on something much more interesting than interest.

Credit card terms and interest rates vary, so find out what a tax refund payday would do for your specific situation by using a calculator like this.

Pay down student loans

If you have no high interest credit card debt, congrats!  But not so fast – before that tax refund slips through your fingers, take a look at how it could impact your lower interest rate student loans.  A few thousand dollars might feel like a drop in the bucket for the average student loan balance of $23,300 (let alone the average debt load for those with graduate or medical school loans, which is closer to six figures).  But no matter what your loan balance is, every dollar you pay over the minimum helps to reduce the total interest you pay over the life of the loan.

For example, putting $3000 toward your $23,300 student loan balance (6.8% APR, 10-year term) would save you about $1100 in total interest and reduce your monthly payment by about $35.  Just make sure your payment is allocated to your loan’s principal vs. being earmarked for future payments.

You can do the math on your own student loan/refund situation with this calculator.

Start (or add to) an emergency savings fund

Experts agree that having an emergency savings fund to cover at least six months of expenses is the foundation of financial wellbeing.  And yet, roughly 75% of Americans live paycheck-to-paycheck, with no cushion to cover them if their income suddenly disappears.

In defense of the under-funded, there may be some behavioral finance principles at play here.  A recent University of Pennsylvania study found that the longer you pursue a goal, the farther away it seems – which makes it easy to get sidetracked or give up before the goal has been achieved.  The beauty of using a windfall like your tax refund to build your emergency fund is that you’ll see immediate, significant progress toward your total savings objective.  Just make sure you take advantage of that momentum and keep saving until you’ve got six months worth of expenses in the bank.

Start (or add to) a retirement account

If building an emergency savings fund feels like a difficult prospect, amassing the amount of money needed for a comfortable retirement can seem pretty much impossible.  But just because it’s overwhelming doesn’t mean you can ignore it.  If you’ve put your retirement savings on hold for any reason, the time to get back on track is now – and your tax refund can help with that.

Let’s say you invest $3000 in a tax-deferred account today and don’t touch it for 20 years.  If it experiences a modest annualized return of 7%, at the end of that timeframe you would have $11,600.  If you added just $50 each month, you’d have almost $38,000.  If you added $100 each month, you’d have about $64,000.  And so on, and so forth – you get the picture.

You can do the math on your own investment scenario with a calculator like this. Or, use this retirement calculator to see if you are on track for your goals.

As a final note, it’s worth taking a moment to see what caused you to get a refund in the first place (particularly if it’s a big one).  Getting money back from Uncle Sam can feel like a windfall, but in reality this is money you could’ve been saving, investing or using to pay down debt over the previous year.  Double-checking your W-4 exemptions and working with a tax professional can help you strike the balance between owing money and getting a huge refund before the next tax season rolls around.

DISCLAIMER:  This article is meant to provide useful information on the topic, but it does not purport to provide tax advice.  You should consult with your own tax advisor for guidance based on your specific situation.


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