Although a tax return means you've given Uncle Sam an interest-free loan over the course of the year -- something that probably isn't the best thing to do if you're a mature adult who knows how to handle money -- it can be a financial boost for many individuals and family in the early part of the year. In a sense, you've been forced to save over the year (you can think of it as forced savings account) and now you are to decide what to do with that savings.
Don't make the mistake of thinking that your tax refund is some sort of windfall or a gift from the government or some sort of unexpected gift that you didn't earn - your tax refund is literally your own hard-earned money that you've been forced to pay the government over the course of the year. Keeping this in mind, you should treat your tax refund like you should treat all of your money: with care, planning, and prudence. Below are a few key things you can do with your tax refund to improve your financial situation and add a bit of financial peace to your life.
1. Start or Bump Your Emergency Fund
This is Number 1 on our list of things to do with your tax return because for most people a strong emergency fund is the single best first step then can take to securing a better financial life.
Those that have some sort of guaranteed income might not need a rainy day fund as much as everyone else because there is far less volatility in their monthly income - for the rest of the world an emergency fund stands in between you (and your family) and financial disaster, stress, and worry should something unpleasant happen (and in this life, something unpleasant usually does happen every once in a while).
Getting your emergency fund to a solid level (typically 3 to 6 months of living expenses) is usually even more important than paying back even high-interest debt. A person with a large amount of credit card debt and nothing in the bank at all clearly is exposed to a lot of suffering if he/she loses their source of income or if an unexpected event or emergency comes up. Of course paying down the debt is very important, but without an emergency fund, there is too much exposure to even the slightest financial emergency.
Without any money, a job loss, a flat tire, a leaky roof, prolonged sickness or any other of the many things that can go wrong, will lead to a lot of pain in your life. Having even $1000 in the bank will help shield you and having a full 3 to 6 months of living expenses in the bank will give you a very pleasant calm in knowing that you've got enough stashed away to make it through most financial emergencies.
If you don't have an emergency fund, a tax refund can be used to start one at your local bank - better yet putting that money into an online savings account where it's a bit harder to reach might be a better option.
2. Pay Down High-Interest Debt
If you already have a proper emergency fund in place, the next best thing to do with your tax refund is to pay down high-interest debt. Such high-interest debt can be credit cards, personal loans, consumer lines of credit, and car loans, etc. These all qualify as bad debt in most cases - things like student loans, mortgages, and business loans (although clearly undesirable) are better because they generally carry a lower interest rate (because they are backed by either tangible assets or are not-bankruptable) and are generally taken out for thins that increase in value over time. Paying down high-interest debt will save you money on interest, will strengthen your overall financial position, and will bring some peace into your financial life.
There are two options when paying down credit card debt:
- pay off the smallest balance to build momentum and feel good (this is what Dave Ramsey advocates)
- focus on paying balances with the highest interest first without regard to the balance size (this is the best approach from a purely mathematical approach)
Generally, either of the above will work and actually pay down debt aggressively is more important than which of the above methods you choose. However, you can decide how to approach paying down your debts based on your own understanding of your personality - if you're the kind of person that might need a momentum boost by seeing a credit card fully paid off, then maybe focusing on the smallest balance is better for you even though it's not the best approach from a purely mathematical standpoint.
3. Take Advantage of a Bank Offer
If you've already got your debt situation under control (meaning you don't have credit card debt or other high-interest debt as described above), then you might consider using your tax refund to get even more money via a bank offer where you get a bonus for opening up a savings account.
Online banks such as Capital One 360 and even brick-and-mortar banks such as Chase often offer bonuses for opening up a new savings account. The general gist of it is that if you deposit a certain amount of new money (eg. $10,000), you get a bonus.
One offer online was for a $200 bonus for a $10,000 deposit - this equates to an almost immediate guaranteed return of 2%. To get 2% in the markets you would have to expose your money to a bit of risk. To get 2% in a guaranteed way (like you're getting with this bonus) you would likely have to lock away your money (circa 2017) for a period of at least a couple of years. Clearly, an almost immediate 2% gain is quite lucrative a low-interest rate enviroment and taking advantage of such an offer could give you extra boos on top of your tax refund.
4. Open an IRA
If you don't have an IRA and if you're not currently contributing the maximum amount allowed, opening an IRA could be a useful way to store your tax refund and it can help lower your tax burden next year (as long as your income during the year in which you're putting the money into the IRA at least is as much as your putting in). You might want to speak to your tax professional about the best way to approach it and if this is really a good idea for you, but for most people, an IRA can help lower taxable income and, thereby, lower the overall tax burden for next year.
5. Start a College Fund for Your Kids
If your financial house is in good shape, it might be time to start thinking about college for your kids (or their financial future in general). Whether college is a few years away or whether you have a newborn, saving for college is always a prudent idea and it will greatly benefit both you and your children.
A good idea is to save the money in a place where it can be used for non-college expenses. The world is rapidly changing and if your child is very young, it is not easy to predict what the academic or occupational landscape will be like in 15 years - college might be drastically different and so might college expense. Therefore, it is prudent to save in a place where your hands won't be tied in terms of how to use the money and where you won't have severe penalties if you or your child chooses to use the money for non-academic expenses (eg. starting a business, paying for a wedding, buy a house, or whatever other hopefully useful endeavor he or she chooses to embark on).