Tax season has arrived. This means you’ll either owe money for underestimating your taxes or the IRS will be sending a tax refund your way. While this seems like a compelling time to splurge on that thing you’ve been eyeing, the FCAA urges you to pause and look to the long term. Yes, we realize this isn’t the “fun” choice. However, choosing how to spend your tax refund wisely may make life a lot more fun and much less stressful in the years to come.
In this article, we will share why you are receiving a refund and discuss four smart ways to spend your tax refund.
A tax refund means you overpaid the government
This happens because your taxes were not estimated correctly. To fix this, make sure you are filling out employee tax forms for optimal benefit. Also, double-check your estimated earnings and update your tax deductions.
Remember, you can make more money by paying the correct amount of taxes and investing your income rather than receiving a tax refund from the government.
Change how you think about tax refunds
If you overpaid on your income taxes and get a tax refund, that is okay. Don’t beat yourself up, but also don’t think of your refund as extra money.
Instead of planning a shopping binge, reframe your thoughts about your tax refund. Consider it a way to pay off credit card debt, save for emergencies, help your kids with college tuition, or save for retirement.
If this sounds like an unappealing way to spend a windfall of cash, focus on the future benefits. Remind yourself of your goals with a vision board or area with a few photos of what you hope to achieve.
Ways to spend your tax refund wisely
1. Pay off high-interest debt
One of the best ways to spend your tax refund is to pay off high-interest debt, like credit cards and some student loans. Escape the credit card trap by using your tax refund to pay down your highest interest-rate debt.
When you borrow money through a credit card or unsecured loan, you’re taking money from yourself in the future. Whatever you purchase now reduces the amount of money you have for other things in the days ahead.
By paying off debt with your tax refund, you will regain the freedom to do more with fewer constraints. Additional benefits of paying off debt include reduced stress, improved credit scores and the ability to own assets like a home or car.
If your debts are more than your tax refund, there are other ways to get out of debt. Debt management, debt settlement and debt consolidation are a few of your options. This article explains these strategies and how they differ. You can also use FCAA’s Debt Freedom Tool for some immediate, practical help to create a budget.
2. Create or contribute to your emergency fund
Create an emergency fund with your tax refund money to prepare for unexpected events in your life. Saving for emergencies gives you a financial safety net or cushion, so you don’t have to rely on credit cards or loans. When your heater stops working, your car breaks down or you lose your job, an emergency fund absorbs some of the financial shock.
An easy way to create an emergency fund is to open a separate savings account and designate it for emergencies. Once you set up the account, create an automatic transfer to the account each month. This ensures that you are regularly saving for emergencies and replenishing any money you may need to use.
A good rule of thumb for how much money to keep in your emergency fund is three to six months of living expenses. The specific amount to keep in your emergency fund depends on your situation, job stability and comfort level.
3. Save for your children’s college education
The price tag for a four-year college degree continues to grow, as do the stories about people struggling to repay student loans. Saving money from your tax refund for your children’s education may prevent them from burdensome student loan repayments in the future.
Parents have an opportunity to save for their children’s education through state-managed 529 plans. These plans offer tax advantages like savings on state income taxes or not taxing growth on the money contributed to 529 plans when withdrawn for education purposes.
Saving for college early through a 529 plan allows the money to accrue interest and grow over time. So, opening an account early and contributing on a schedule or as you are able is a wise investment move.
Financial experts recommend saving as much as you reasonably can for your children’s college education but not at the expense of your retirement savings. This leads us to the last way to spend your tax refund wisely.
4. Save for retirement
Another way to use your tax refund wisely is to save for retirement, whether with a traditional IRA or another tax-deferred investment account. Every contribution you make now will increase your future quality of life. An intentional plan and consistent savings are key to achieving the retirement you want.
If you planned to live exclusively off Social Security during retirement, please reconsider. Social Security was never intended to fund retirement fully. The Social Security Administration says a retirement income of about 70 percent of your working income is adequate for retirement. Social Security benefits typically account for only about 40 percent. With our rapidly aging population and a stressed Social Security system, basing all of your retirement plans on the government is not a good idea.
Financial planners regularly advise clients to prioritize saving for retirement over saving for college. The logic behind this rationale is that you can borrow for college. Few opportunities exist to borrow for retirement. Thus, if you don’t save for retirement, your older years will be more financially difficult.
Retirement savings give you financial security and comfort. A well-funded retirement account will also prevent you from burdening your children with your financial needs.
Adding your tax refund to your retirement savings is a great way to grow an existing account or start one. Then, plan to contribute to your retirement account regularly. The key to retirement savings is investing over time. Contributing early in your career allows your retirement account balance to grow through the years with compounding interest.
Celebrate your smart financial choices
Making wise choices with your money may be tough at first, but it will help you reach your financial goals in the long term.
If making these trade-offs still sounds challenging and you need some short-term gratification, then use a little bit of money to reward yourself for your good financial choices. A small treat could be as simple as a coffee date with a friend or going to the movies with your family.
Get help if you feel trapped by debt
Don’t suffer under the stress of looming debt. Take your first step to a healthier, financially stable life by being disciplined in how you spend your tax refund.
If your debt is so great that you still feel overwhelmed and need help, FCAA’s non-profit credit counseling members are an excellent resource. Check out our Debt Freedom Tool, which will help you analyze your budget and connect you with a certified credit counselor.