Unless you have a quirky fascination with 1040 forms and tax code, filing your tax return is a mundane, tedious endeavor at best. A silver lining? The potential refund you might receive. As the average return for individual taxpayers in 2018 was $2,899, even with returns being down this year, there may be a decent chunk of change to work with.
If Uncle Sam is cutting you a tax refund check this year, what’s the best use of that small windfall? If you’re feeling paralyzed by the dizzying bounty of choices, here is a simple set of guidelines to help you decide:
DIY Route: List Your Priorities
Not sure where to spend that refund money? When it comes to personal finance, the emphasis is on personal. Your financial priorities might not look the same as those of your friends, co-workers, neighbors, and family members.
To gauge where you’d like to spend your refund, make a list of all your financial priorities. It might include paying off debt; saving for a house, vacation, or new car; or squirreling away money for an emergency fund or retirement. Next, narrow down your focus to the top three priorities. List target dates and specific amounts. For instance, you’ll want to save $3,000 for a trip to Iceland by October of next year. Or, you’d like to save $20,000 for a down payment on your first home by the end of 2021.
Why are these three the most important? As in the case of high-interest debt, would you save on the interest fees by knocking out that debt sooner rather than later? Or would you and your partner like to have a down payment for your first home within the next two years? If you’d like a step-by-step plan, here are some recommendations:
Save for an Emergency Fund
A recent survey by Bankrate reveals that one in five Americans aren’t saving any of their income. Here’s the thing: without a sufficient cash reserve, an unexpected expense — car or home repair, vet bill, job loss, or medical expense — could really be a blow to your finances.
To avoid this, consider saving your tax refund toward your emergency fund. While you might be tempted to use that money toward other money goals, having a sufficient rainy day fund will prevent you from racking up more debt.
The general rule of thumb is to set aside three to six months worth of living expenses, explains AnnaMarie Mock, CFP® of Highland Financial Advisors. “This can vary from person to person, and households with one income or self-employed individuals might want to consider keeping 6 to 12 months — or more — of cash on hand.”
Pay Off High-Interest Debt
You’ve probably heard of “bad debt” and “good debt.” Good debt usually refers to debt that has a low interest rate and is used to purchase an asset that could grow in value over time or eventually produce income. For instance, good debt could be a mortgage on a home, or a small business loan. You may also be able to deduct some of your “good debt” for tax purposes.
Bad debt, on the other hand, has high interest, and is used to purchase assets that are depreciating. Common forms of bad debt are credit cards, and personal loans to fund vacations.
“Try to pay down the inefficient, higher-interest rate debt first because the cost to carry the high-interest rate debt can be astronomical,” says Mock. Compounding interest will increase your monthly payment. That’s because it applies to the principal and the interest already accrued. “To see how much your high-interest debt is costing you, do some simple calculations using an interest calculator.”
Invest Your Refund
If you have money tucked away for the unexpected and are making progress in paying off your high-interest debt, consider investing, which will help build your wealth. To maximize your savings, take advantage of account diversification, says Mock. “Roth IRAs and Roth 401(k)s are a great alternative to a Traditional IRA and 401(k) for young professionals.”
Mock further explains: “The Roth option allows an investor to save after-tax dollars in the account, so you won’t get a tax deduction today. However, the money will grow tax-free.” Contributions you make with a traditional IRA and 401(k)s are made with pre-tax dollars, which means you don’t have to pay taxes on them until you take out contributions.
Figure Out How Not to Receive a Refund Next Year
While it’s exciting to receive a robust refund, you might want to see about holding on to some of the money Uncle Sam is taking out of your paycheck. If you’re withholding too much on your taxes, that’s money you could have each month to put toward your money goals year-round. Invest in tax planning to figure out how to not receive a refund next year, says Jason Speciner, a CFP®, EA, and founder of fee-only firm Financial Planning Fort Collins.
“Use the additional monthly income going forward to accelerate debt payments and/or goal funding.” To change your withholdings, you’ll need to make adjustments on the W-4 form, which you can request from your employer.
Spend a Bit, Use the Rest Responsibly
Receiving a small lump sum of cash and spending it responsibly has its obvious benefits. But to avoid feeling deprived, allow yourself to spend a portion of your return, then put the rest toward a worthy money goal. Allow yourself to spend a quarter of your refund on whatever you like. That will allow you to have a bit of fun. It’s important to balance your future financial needs with enjoying the here and now.
No matter how you choose to slice and dice your tax refund, keeping in mind what’s best for your financial situation will help you funnel that extra cash to improve your money situation, both present and future. It’s important not to lose sight of the bigger financial picture. Remember: short-term decision-making can yield long-term benefits.
If you’d like help with your financial situation, reach out to Money Management International (MMI). Our counselors are available to answer any questions you have and point you toward valuable resources and handy tools.
Jackie Lam is an L.A.-based personal finance writer who is passionate about helping creatives with their finances. Her work has appeared in Forbes, Mental Floss, Business Insider, and GOOD. She blogs at heyfreelancer.com.