Tax season is upon us, meaning a refund might be headed your way. No doubt you’re excited by the idea of a cash influx, but this isn’t free money. “Most people think their tax return is a gift from the government,” said Paula A. Norby Krueger, owner of Norby Krueger Tax & Bookkeeping Services in Wahpeton, N.D.
Of course, this isn’t true—tax refunds are granted because too much money was withheld from your paycheck, meaning you paid more in taxes than you actually owed. Getting some of this money back is a unique opportunity to further some of your financial goals. Here’s a look at good and bad ways to spend your refund check.
5 Things You Shouldn’t Do With Your Tax Refund
1. Make big purchases that require payments. Norby Krueger said it’s unwise to purchase anything with a payment because you’re just incurring new debt. The money from your tax refund might cover the first few payments, and you’ll be on the hook for the rest.
This category is broad, but could include furniture, electronics or even installing a swimming pool in your backyard. One of the most common offenders? Cars. According to Kelly Blue Book, the estimated average of a new car is $36,978, so while your tax refund may make a nice dent, it would be a mistake to ignore your future payments.
2. Splurge. “You’re starting to see retailers push promotions with online tax preparation companies that allow consumers to roll their refunds into gift cards,” said Chris Jackson, CFP and founder of Lionshare Partners, a Los Angeles-based, fee-only financial planning firm.
It can be tempting to spend your tax refund on an expensive handbag or a big-screen TV, but think twice about that. The government is essentially returning money you earned, so don’t waste your hard-earned cash.
3. Take a carryforward. A tax carryforward allows you to save your tax refund to pay any taxes you’d owe the following year. If you pay quarterly taxes, this may be a good idea. But for most Americans, it’s not the best use of the funds.
“Unless you are incapable of not spending your money, do not carryforward the tax refund into the new year,” Jackson said. “That is an interest-free loan to the government.”
“Instead, you should pay down debt, max out retirement plans or increase emergency funds,” he said.
4. Nothing. Allowing your tax refund to sit in your checking account might seem like a responsible move, but it’s actually unwise. If it’s just sitting there, you’ll likely be tempted to use it.
Even if you have seriously impressive self-restraint, Jackson said that cash is an asset class that can and should be managed. Take advantage of high-interest savings accounts or consider a short-term bond ladder — i.e., a bond portfolio composed of different maturities.
5. Make hasty investment decisions.“Investors have to first identify what their goals are in order to select appropriate investments that make up their overall asset allocation,” said Levi Sanchez, CFP and founder of Millennial Wealth, a Seattle-based fee-only virtual financial planning firm.
Whatever you do, don’t just get caught up in investment hype, especially if you’re just entering the market. Take the time to learn about strategies that are the best for your financial situation, and consider reaching out to a financial advisor for guidance. Sanchez advises investors who don’t want to actively manage their portfolios on a weekly or monthly basis to consider passive investment vehicles, like index funds and ETFs, i.e., electronically traded funds.
10 Things You Should Do With Your Tax Refund
“If you receive a nice windfall of cash from your tax return, consider how it can impact your financial situation if you put it to good use,” Sanchez said. “Whether that’s paying down high-interest debt, saving for a home down payment or putting [it] toward long-term investments.”
Improve your financial situation by using your tax return for one of these good causes.
1. Save for retirement. If you’re not saving as much for retirement as you’d like — or aren’t at all — take this opportunity to pad your account. In an ideal world, you’ll have 25x your annual expenses in your retirement account when you retire.
“If you are maxing out your tax-deferred vehicles — 401k and HSA — then use those tax savings to invest in a Roth IRA,” Jackson said.
2. Contribute to a 529 plan. “A lot of consumers are ignoring their retirement in lieu of college funding when they can do both,” Jackson said. “They can fund their 401k and use the tax refund to fund a 529 plan.”
If you’re not familiar with 529 plans, these tax-advantaged educational savings tools allow you to put money aside for educational expenses. Two types of plans are available — prepaid tuition plans and education savings plans — and all fifty states and the District of Columbia sponsor at least one of these options, according to the U.S. Securities and Exchange Commission.
3. Start an emergency fund. According to a report from the Federal Reserve, 40% of Americans do not have enough cash on hand to cover a $400 unexpected expense. If you’re lacking an emergency fund, or if it isn’t equipped to handle six to 24 months of expenses, Jackson recommended using your tax refund to pad your savings. Being prepared for unexpected costs will bring you peace of mind and can keep you from going into debt.
4. Invest in yourself. “Your ability to convert human capital into financial capital is the key to economic freedom,” Jackson said.
He advised boosting your human capital by improving or acquiring new skill sets. For example, you might take an online course that will give you the credentials required for a promotion at work.
5. Pay off credit card debt. In 2018, Americans paid $110 billion in credit card interest and fees, according to a MagnifyMoney analysis of FDIC data through September 2018. If you’re in debt, this is an opportunity to pay it down or maybe even eliminate it.
And once you do, stick with it. “Make a commitment to yourself not to go back to using the credit card,” Norby Krueger said. “Get out of debt and stay there.”
6. Make home improvements. Fixing up your home in a manner that adds equity can be a sound investment, Norby Krueger advised. A few projects that add value to a home include updating the kitchen, finishing the basement and making the house more energy efficient, according to Consumer Reports.
7. Save for a down payment on a home. As recommended by Sanchez, putting your tax return toward a down payment on a home can be a wise investment in your future. If you’re buying your first home, your down payment can be as low as 3.5% of the purchase price with an FHA loan. Most lenders offer conventional loans starting at 5% of the purchase price, but private mortgage insurance is required when you put down less than 20%.
8. Opt for experiences over things. If you want to use your tax refund for something fun and your finances are in good shape (well-funded emergency fund, no credit card debt, on track for retirement) consider traveling instead of shopping. Experiences create memories that last a lifetime, while most objects have a shelf life. Just make sure your vacation doesn’t exceed your budget.
9. Make charitable donations. If you truly don’t need the money, consider donating all or part of your tax refund to a charitable cause close to your heart. As an added bonus, if your contribution meets IRS requirements and you can itemize your taxes, you might even be able to write it off as a deduction.
10. Make an extra mortgage payment. Own your home outright faster than planned by using your tax refund for an additional mortgage payment. Make sure the second payment is put toward your loan principal.
Receiving a check from the IRS is exciting, but don’t forget this is money you worked hard for. Wasting money never feels good, so think long and hard about the best possible use for your tax refund.