What to do with your income tax refund
Updated: September 1, 2015
April 15 has just passed¹. With a little luck, you may have come into some extra money – Uncle Sam or your home state (or both, if you were very fortunate) may have sent you a refund check. What should you do with it?
You just know that a financial planner isn’t going to suggest that you buy a new sports car, or take a lavish vacation. Financial planners are sober-sided, conservative folk (and we at Sensible Financial™ have to be sensible, besides).
You probably know intuitively that it’s easier to save out of a windfall than out of your regular income. Economists have done some work that confirms your intuition. Basically, people who increase their saving out of their income tend to view that as a reduction in their standard of living, and they really resist that. Saving out of “found money” is much easier.
So, save that money. But where? Here are five great ideas, in priority order:
- If you are carrying a credit card balance, pay it down, or better yet, pay it off. Credit card interest rates are usually punitive, and the interest payments aren’t tax deductible. Paying off your credit card balances is the first step toward establishing your sustainable living standard – a key to financial peace of mind. Then, keep the balance at zero. This may not seem much like saving, but reducing debt increases your net assets (assets minus debts), so it counts. Plus, reducing your debt and the associated interest payments is guaranteed to make you feel better!
- Build up your “rainy day” fund. You can call on this reserve if you lose your job, or have a family emergency that requires your full attention. For many families, this account isn’t nearly big enough. As a rule of thumb, it’s good to have 6 months of spending (including mortgage payments or rent) in a reasonably liquid, taxable (and thus accessible without penalty) account. Roughly speaking, if you spend everything you earn, except for contributing to your 401(k) plan, you should have 6 months of take home pay in this account. [If you do start or add to a “rainy day” fund, you should keep it in an account that is a bit difficult to reach so you’re not tempted to tap it except in a true emergency.]
- Increase your 401(k) contribution by the amount of your refund, especially if your employer will match it. This earns a very high rate of return on your money right off the bat – a 50% match is an immediate 50% return – pretty tough to beat. Of course, if you’ve already maxed out your 401(k) contribution, you can’t increase it.
- Contribute to an IRA (either traditional deductible or Roth) to start earning returns right now². If you don’t qualify for either one, you should contribute only if you intend to invest the contribution in fixed income assets, or if you have a relatively long time horizon before drawing on the assets (capital gains tax rates are lower than the ordinary income tax rates that IRA earnings are subject to).
- Start or add to your child’s 529 or other college savings account. The earnings are tax free if used to fund your child’s college education. Anything you can sock away now means more consumption and/or less borrowing later.
Of course, you may have used up all of these opportunities. You can save the refund anyway. Put it in mutual funds, hold it for a down payment on that second home you’ve been thinking about buying (or as a start on some other dream you have that requires some scratch).
The planner in me can’t resist making two additional points:
- Only a comprehensive financial plan can tell you how much you should be saving each year (and how much you should be saving in your retirement accounts versus college savings, etc.). If you have a plan, you’ll know whether or not you can spend some of your refund – and how much.
- If you save a good chunk of your refund, you’ll feel better about spending the rest of it. Alternatively, spending a little of it is a good reward for saving the rest (and will encourage you to save from next year’s refund).
So – save that refund – you can even save it all in one place!