It’s the most wonderful time of the year for some — the season in which your state and federal government pays its debt to you in the form of a big, fat tax refund. If you’re expecting Uncle Sam to be generous this year, it’s tempting to spend the money on luxury items or vacations as soon as it hits your bank account. But before you blow the whole payoff on a few fun, short-term whims, here are some practical uses for your tax refund that have long-term benefits for your overall financial health.
Most economists would say that you should not be getting a large refund; if you do, you should adjust your withholding to reduce the amount of tax taken from each paycheck. Otherwise, you are giving the government an interest-free loan.
You want to be smart with any windfalls, including an income tax refund. Behavioral economists have a term called “mental accounting,” which means that we tend to treat money from different sources differently. The extreme example would be saving up for a vacation while also having high-interest credit card debt from the last vacation, even though you’d be better served paying off the credit cards.
And yet, most of us have a hard time with the idea of simply blending any new money into existing accounts, even if that’s the rational route. We’re trying to manage risk in a wildly unpredictable world.
With that in mind, use mental accounting to your benefit, not your detriment. When you receive your income tax refund, it’s okay to allow yourself a little treat. It may not be completely logical to run out and buy new shoes or take the family out to dinner when you also have debts, but sometimes, it’s nice to do. Don’t blow all of it, though. Think about having fun with 10 percent of the refund, then using the rest to improve your financial situation.
Here are 10 smart ways to use your income-tax refund:
- Invest in yourself. This could mean taking a class in investing, studying something that interests you or even taking a big trip.
- Put it in your IRA. Ideally, you’re saving for retirement with automatic deposits into a 401(k) or IRA account. But if you’re like most people, you rarely have the extra money to contribute the maximum amount allowed. If you have a significant number of years before you retire and some investing luck, a couple of thousand dollars put away today has the potential to grow exponentially.
- Seed an emergency fund. Experts recommend having three to six months of living expenses in a savings account just in case you lose your job, or something major happens. Of course, that’s not feasible for everyone, but every little bit helps. Your tax refund away is a great way to get started saving for a rainy day, and then you can continue to add a few bucks a week to it. This cushion can help cover things like home-appliance breakdowns or a temporary loss of income so your unexpected expenses don’t wind up on your charge cards.
- Take care of a health issue you’ve been putting off because of the cost. Whether it’s getting new glasses or taking care of a pricey dental problem, being able to do those things before they reach “I have no choice” emergency status is a blessing.
- Lighten your bill load. If you don’t have any credit-card debt (hooray!), you could tackle another bill that tends to sneak up at inopportune times, like your car insurance, for instance. Or, you could speed up the repayment of a student loan or an auto loan by plunking down a lump sum.
- Pay off a high-interest debt. If you’ve been battling the same credit-card balance for some time now, putting a lump sum of cash toward it will save you hundreds of dollars in interest, and get some of your monthly bill burden off your back. Then, your extra cash flow moving forward can be used for better purposes, like saving for your next vacation.
- Improve your home. Consider putting your refund to good use by adding insulation, replacing old windows and doors or other improvements that would save energy, and therefore money. Or perhaps it’s time to remodel your bathroom or kitchen. You’re adding value to your home at the same time you’re improving your living experience.
- Apply your refund toward next year’s taxes. This is common among self-employed taxpayers, who are required to pay quarterly taxes since they don’t have taxes withheld. By applying any overpayment toward upcoming tax payments, you can free up other cash.
- Splurge on something you’ve always wanted to do. If you’re out of debt and have substantial savings, this may be the time to take the trip to Antarctica or Australia that you’ve always dreamed of taking. Such an experience can be life-changing, and you never know what impact it will have on your future until you actually do it.
- Save some money for fun. No matter what you decide to do with the bulk of your tax refund, go ahead and set aside a small percentage of it to enjoy guilt-free. Everyone deserves a splurge now and then, whether it’s dinner out at a nice restaurant, a massage or even a weekend getaway if you can swing it.
How have you spend tax refunds in the past? What are you planning to do this year?