If you received a tax refund from Uncle Sam this year, you shouldn't celebrate just yet. Aside from the fact that it was your money to begin with (not a friendly gift from the government), you may have some adjusting to do before next tax season rolls around.
If you are having too much withheld from your paycheck, you are basically lending the government your money for free. What's worse is that you are losing out on time that your money could be growing for you. If this is the case, be sure to adjust your federal income withholding allowances or revisit your W-4. That is not to say that a lump sum of cash from the government doesn't make you feel good. With that being said, don't get caught treating your refund any differently that you would your paycheck. Your money is valuable, and just like your paycheck, each dollar of your refund should be given a purpose.
In 2020, the average tax refund payment was more than $3,125 according to the IRS. If you are one of those people who received a tax refund this year, before you squander your tax refund on a vacation or another big ticket item, first consider a few ways you can make that money work for you.
Here are several suggestions for what to do with you tax refund:
1. Contribute to Your Emergency Fund
Have you considered what would happen if you were laid off from your job unexpectedly, or faced a big unexpected expense? If you aren't prepared for this or a slew of other misfortunes that you could be faced with, you may want to consider holding on to your tax refund.
At least a few months of easily accessible "rainy-day" cash is recommended. Although it has been said by some financial experts that six months to a year of emergency cash is necessary. The extent to which you save for an emergency is largely dependent upon your situation though.
Read our full guide to emergency funds here.
2. Pay Off Your Debt
Possibly worse than an unexpected emergency is a present day emergency otherwise known as debt.
If you are one of the many Americans faced with high interest debt, you should be focusing on cutting expenses and channeling every free dollar into your debt. Furthermore, it is often recommended to pay off your debt before even starting an emergency fund (we don't agree, but you still shouldn't avoid paying off your debt).
The logic behind this is that if you're already in debt and you burn through your emergency fund, you will be without the financial option of borrowing money. Borrowing money on credit cards is never an attractive option, but in dire circumstances it may be necessary.
If you have student loan debt, now might not be the best time to pay those off (due to all the Covid-19 student loan programs). Instead, focus on other debt like credit cards or auto debt.
3. Save More for Retirement and Other Goals
If your financial house is in order and you've accumulated a healthy emergency fund and you are debt-free, another option to consider for you tax refund is to invest it.
The average American is not allocating enough money to retirement. Many financial advisors recommend investing 10% to 15% of your annual income to retirement, but obviously with the time value of money, the earlier you invest, the better.
If you got a late start on investing, it is never too late to bridge the gap. A $3,125 tax refund will certainly help get you closer to your goals. In fact, that amount would be half of what you can contribute to your IRA this year.
4. Refinance Your Mortgage or Make Home Improvements
Mortgage rates are at all time lows. If you're financially prepared and ready to buy, there really is no better time. If you already own a home you can take advantage of these interest rates by refinancing and paying for your closing costs and fees with your refund. This will allow you to save money immediately in interest payments.
If you are really ambitious, you can keep paying the same monthly mortgage amount, and cut away at the principal you owe. Furthermore, if there is a high dollar project that you have been putting off, now may be the perfect time to knock it off the list. Home improvement projects are a great way to add value to your home and usually the benefits are immediate.
5. Invest in a Taxable Account
If you've already maxed out your tax-sheltered accounts you are definitely ahead of the pack and you probably don't need to hear this advice. Opening a brokerage account can be a great way to further diversify your portfolio and make your money grow for you.
Since these investments are fully taxable, it may be a good idea to steer towards low expense investments or tax efficient mutual funds or ETFs.
6. Give to Charity
Depending on who you are this may be number one on your list. For others on a tight budget, giving to charity can be difficult. A tax refund is a chance to contribute to a charity of your choice.
Giving to charitable causes may not give back in the form of dividends or capital gains, but sometimes the benefits a donation can create are more valuable than anything money could buy. Not to mention you can deduct charitable contributions on your taxes.
7. Start Your Own Business
If you have a business idea that you've been putting off, a refund may be just what you need to get things off the ground. This is a great way to see return on your investment, and tax deductions can be taken on your small business as well.
If you don't know where to start, we have a list of the 15 best online business ideas you can start right now at home.
Bonus: Change Your Withholdings To Not Receive A Refund
An option you may not have thoughts about is simply changing your tax withholdings from your paycheck so you don't get a refund - but rather owe. That might seem crazy, but remember, a tax refund is just a refund of extra money you've paid to the IRS all year. It's your money!
If you change your W4 withholdings on your paycheck, you'll get bigger paychecks all year long. Then, at tax time, you would pay any difference you owe. This is something that most savvy investors and high net worth individuals do. Never let the IRS get extra money that belongs to you.
The only drawback here: you need to plan to write a check to the IRS in April. If you don't save or have the money, you could be in trouble. So, before you go adjusting your withholdings, make sure you have a plan.
Regardless of how much of a refund you are receiving, if you are receiving one at all, a tax refund should be treated with just as much value as any other dollar you have earned. If nothing else, it should be treated with more value, since you are basically being paid for work you did throughout the year.
Whether your refund was expected or not, it should be used in the way that is most advantageous to wherever you are in life. As tempting as it is to treat yourself to something that you want, just like all of your hard earned dollars, investing in something that will advance you in your goals is far greater than any item that could be bought in a mall.
What other investment ideas do you have for your tax refund?
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.