There are few events in the world of personal finance that are more satisfying than receiving a tax refund. All of sudden, your pockets swell with some extra cash. So, how should you spend your tax refund?
The importance of financial planning comes into especially stark contrast whenever a windfall comes your way. Being judicious with your tax refund can go a long way towards helping secure your long-term financial goals.
What To Do With Your Tax Refund?
For most, taxes do not instill feelings of joy. Beyond the headache of filling out their annual tax returns, some need to send an additional check to the U.S. Internal Revenue Service.
Many people, however, have had their employers deducting more than enough taxes throughout the year. They can therefore expect to receive a tax refund after they complete their filing. These tax refunds can be in the hundreds or even thousands of dollars, a sizeable sum that they can use to pay down debt, save for retirement, or spend on that fancy new gadget.
Any tax refund represents an opportunity to go above and beyond the confines of your monthly budget. It is also a chance to think about your goals and priorities.
For instance, if you have a stated goal of becoming a homeowner, it would be a wise decision to allocate these monies to help you save for a down payment on a house. Or, perhaps you are aching to fight your way out of credit card debt, in which case you should prioritize repaying these wealth-destroying obligations.
Your decision about where to use this money will therefore depend on your own financial situation.
What Is the State of Your Finances?
Everyone has a unique combination of personal assets, liabilities, and preferences. Before making any financial decisions of significance, it is important to understand the state of your finances.
In particular, think about the following questions, in descending order of importance:
(1) Are you in credit card debt? In the pyramid of priorities, clawing your way out of credit card debt, with high interest rates that often compound daily, should be at the very top. Credit card debt has a particularly toxic effect on your finances, as it ramps up quickly and can ruin your credit score. If you have the option to pay this off (or decrease it) thanks to your tax refund, this is a worthwhile way to use these monies.
(2) Do you have an emergency fund? Emergency funds are dedicated pots of money that you can use to pay for the unexpected. Not having one in place if the need arises can leave you in either credit card debt (see above) or raiding your retirement accounts (see below). If you do not have one already, think about using your tax refund to establish a fund to deal with unplanned potholes on the road of life.
(3) How are your retirement savings? Whether you have a employer-sponsored 401(k) plan or an Investment Retirement Account (IRA), chances are that you are not maxing out your yearly contributions. (These are currently $7,000 a year for IRAs–$8,000 if you are over the age of 50–and $23,000 for 401(k) plans.) Using your tax refund toward your growing retirement accounts will help you to save for your golden years.
(4) What are your other long-term financial goals? Whether you are looking to buy a house, save for your children’s college expenses, or pay off your auto loan, your tax refund can contribute to these aims. Even if you do not have a specific objective in mind, putting the money into a savings or investment account will allow these funds to grow through the years. If you invest them wisely, they will be even larger when you do have a more defined goal in mind.
What Not To Do With Your Tax Refund
The worst thing you can do with a tax refund is to think of it as free money, and rush off to spend it on the latest and greatest consumer goods.
In fact, the opposite is true. This is your money, that you have in essence loaned to the U.S. government interest free. Therefore, think about the best ways this money–your money–can serve you.
While it can be tempting to enjoy a spending spree at the local mall, head to the race track, or jet off for a weekend getaway, think long and hard about your long-term goals and how responsibly managing your finances will help you reach them.
Some tax preparation services offer prepaid debit cards. If you are concerned about your impulse control, avoid getting your refund in this manner.
That does not mean that cannot treat yourself to a nice evening out with friends or another small gift to yourself. After all, you have earned this refund by dint of working hard throughout the year. But, you should not take these funds as a license to spend frivolously.
Conclusion: Staying the Course
Tax refunds have similarities with other types of windfalls, such as bonuses, gifts, or inheritances. Once any taxes and fees are paid, you now have an additional sum of money to save or spend.
If you wish to be a responsible steward of your finances, any newfound money should fit into your existing plans. The tax refund will not provide you with the means to drastically upgrade your lifestyle, and your spending choices should remain consistent.
Remember: Your goals have not changed, and neither has your annual income. You have received a nice boost to help you continue on your financial journey.
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