7 Ways to Make the Best Use of Your Tax Refund
Did you get a tax refund for 2021? The average is about $3,000 this year. No matter how much you got, the key is to make the best use of it. Here are some options to consider in general order of priority:
1) Get caught up on old bills. For many of the people we talk to on our financial coaching line, a tax refund can be a lifeline to get caught up on overdue mortgage payments and other bills. This can prevent you from losing your home or car, save you money in interest and penalties, and stop future damage to your credit report. However, you may want to think twice about paying that debt if you're planning to file for bankruptcy or if the debt is old enough to be off your credit report (7 years) and past your state's statute of limitations.
2) Build up your emergency fund. The rule of thumb is to have enough savings to cover 3-6 months of necessary expenses. If you don’t have an adequate emergency fund, you might want to put your refund somewhere safe and accessible like a savings account or money market fund.
3) Pay down high-interest debt. The average household in America has a credit card balance of $6,270 and the average APR is about 16%. Putting $3,000 towards that debt could shave over 4 years off the payoff date and save over $3k in interest.
4) Contribute to an HSA. If you’re in an HSA-eligible health insurance plan, you may want to contribute to an HSA since the contributions are pre-tax and withdrawals are tax-free if used for qualified health care expenses. (Otherwise, withdrawals can be subject to taxes and a 20% penalty until you turn age 65.) This means the money can potentially avoid ever being taxed at all!
5) Save more for retirement. A one-time $3,000 contribution to an IRA that earns an average annualized 6% return will grow to be worth over $17,000 in 30 years. Contributing every year would grow the account to over $237,000.
Contributing to a traditional IRA can give you a deduction on taxes for 2022 if you meet the income limits. Otherwise, consider a Roth IRA, which doesn’t reduce your taxes now but the earnings can be withdrawn tax free after age 59 1/2 (as long as you've had the account open for at least 5 years). (If your income is too high to contribute directly to a Roth IRA, you can make a backdoor contribution.) In the meantime, your Roth IRA money isn't completely tied up since you can withdraw the sum of your contributions without tax or penalty, so it can even be used for emergency money. (Earnings may be subject to taxes and penalties if withdrawn before age 59 ½, but the contributions always come out first).
Another option is to contribute more to your employer’s retirement plan. While you generally can’t contribute your refund directly to a 401(k) or 403(b) plan, you can increase your contribution rate and use the refund to make up the difference in your paycheck. This is especially beneficial if you’re not contributing enough to get the full match.
6) Put it in an education savings account. If your retirement plan is on track, you can save for your children's education in a 529 or Coverdell education savings account and have the money grow tax free for education expenses. If you invest in your own state's 529 plan, you may be eligible for a state income tax deduction. Just be aware that the earnings may be subject to taxes and a 10% penalty if used for non-qualified expenses.
7) Go enjoy yourself. If your financial needs are taken care of, go ahead and enjoy yourself, but consider splurging that refund on an experience like a vacation rather than a shopping spree. Research shows that you buy more happiness that way than purchasing a luxury item that you really don't need.
For many Americans, the tax system can be their only way of saving for these various goals. The problem is that it isn't exactly the most efficient way of saving since you earn no interest on your money and don't have access to it until after you file your taxes. If you're receiving a large refund every year, you can adjust your W-4 tax withholding and save for these goals throughout the year instead.