Getting a nice, fat tax refund can be pretty exciting. According to the data from IRS.gov, the average tax refund as of December 2015 was $2,918. If you’re the average American you’ve already decided what you will do with the money. You may have earmarked it for a summer vacation, a big-screen HDTV or a down payment on a new car. We understand that a tax refund can feel like free money. But before you do anything else, sit down, take a deep breath and think carefully about this. Sure it would be fun to get a 55-inch HDTV but there are other smarter ways to spend that tax refund. These won’t be as much fun but will be better for you over the long haul. Here are six of them.
Pay down your credit card debt
NerdWallet revealed that the average credit card debt in 2015 is $15,762. We understand that writing a check to one of your credit card companies won’t feel as good as a one-week vacation at the beach. But if you have high-interest credit card debt this can be one of the best ways to spend your tax refund. As an example of this, if you owe $2000 on a credit card at 19% APR and have been making a payment of $100 month it will take you 25 months to pay off the debt and will cost you $414 in interest. On the other hand, if you were to use some or all of your refund to pay off that credit card debt you’d be putting an extra $100 in your pocket every month for more than two years and would have an extra $414 you could apply towards that big screen HDTV. While this is only an example the same would be true of paying off any high-interest debt whether it’s credit card debt, a student loan or an auto loan.
We hope you do have an emergency savings fund. The fact is you’re going to have a financial emergency. It’s not a case of if, it’s a case of when. There is not a financial expert under the sun that doesn’t stress the importance of having an emergency fund. The day will come when your car will need an expensive repair, your roof will need to be replaced or you’ll get sick and miss several weeks of work. If you don’t have an emergency savings fund to cover one of those expenses your only option will be to either borrow the money or take it out of your retirement account – neither of which is a good option. You should really try to have anywhere from 12 to 36 months of your living expenses tucked away in a special savings account so that when an emergency hits you’ll have the money to cover it.
Boost your retirement savings
The Persian poet Omar Khayyam once wrote, “Take the cash and let the credit go nor heed the rumble of a distant drum”. That was his way of saying live for today and don’t worry about tomorrow. Unfortunately, if you follow Omar’s advice you won’t have a very nice retirement and could end up living on a small Social Security check – assuming there still is Social Security 25 or 30 years from now. So, a second good way to use that income tax refund would be to contribute to your 401(k) or traditional IRA. Of course, if you’ve already contributed the maximum allowed to your 401(k) you’ll have to start an IRA and put the money in it. The best thing about either of these options is that you add the money pretax meaning that you pay no tax on it until you withdraw it. This is good for two reasons. First, it will help you secure your future and second it will reduce your taxable income for the year. If you already have a traditional IRA, you might consider opening a Roth IRA. It’s the opposite of a traditional IRA in that you pay taxes on the money when it goes into the IRA but it’s tax-free when you begin withdrawing it.
Consider prepaying your mortgage
Did you know that if you make just one additional payment a year on a 30-year mortgage this will reduce the term of your loan to 22 years? If you’re 30 now think how good it would feel to own your house free and clear when you’re just 52. This can be an especially good strategy as you near retirement as you won’t want to continue making mortgage payments when you stop working and your income goes down. While this doesn’t have to do with your tax refund another great way to handle your mortgage is to refinance it into a 15-year loan. If your current interest rate is 5% APR or higher you might be able to refinance into a 15-year mortgage with an interest rate as low as 3.27%. You could actually end up with a lower monthly payment and own your home free and clear in 2031.
Use your tax refund to spread the wealth
Do you have a charity or religious organization you believe in? This may be hard to fathom but you could feel better about contributing some or all of your tax refund to it than buying an HDTV that will probably be obsolete in just a few years. When you do this you’ll not only feel great but it will mean a nice tax deduction, making it a win-win deal.
Splurge – a bit
Finally, you could splurge and use some of that refund to give yourself a treat. For example, you could use some of it to buy theater tickets you wouldn’t have been able to afford otherwise or just have a really nice dinner out. But don’t go hog wild. Spend about the same percentage on that treat as you would normally spend from your regular paycheck. For example, if you normally budget 5% of your earnings for dining out you might take 5% of your refund and splurge on a great dinner at a top-of-the-line restaurant.
If you’re getting a really large refund
If you’re getting a really large refund, it’s because you over-withheld. You might check your income tax withholding allowances to see whether this is true. If it is, you might want to adjust how much you’re having withheld by completing a new form W-4, Employee’s Withholding Allowance Certificate. Of course, when next April rolls around you won’t have as big a refund but you’ll have more money in your paycheck every payday, which could feel pretty sweet. Here’s a brief video that discusses the two strategies — of over withholding vs. putting more money in your pocket every payday.