Whether a check shows up in your mailbox or a deposit appears in your bank account, getting an income tax refund may feel like “found money.”
Unfortunately, at least part of that tax refund is more like “lost money.” The last thing you want is to consistently get a sizeable tax refund. It may feel like a bonus, but it actually is your repayment from the government of an interest-free loan you’ve made to Uncle Sam. While it’s been in his hands, that money hasn’t been available to earn interest or buy necessities for you.
Because a tax refund can feel like a windfall, it’s tempting to use it to splurge on something fun. Every year, a host of personal finance articles recommend otherwise. Some of the common suggestions for wise use of a tax refund include:
1. Build up your emergency fund.
2. Pay down debt, especially high-interest credit card debt.
3. Add to your retirement savings; start an IRA or contribute to an existing one.
4. Put the money toward a necessary large purchase like a replacement furnace or car repair.
5. Open or add to 529 college savings plans for your kids.
All of these are good ideas. But before you take anyone else’s recommendation (including mine) for the wisest way to use your tax refund, assess your family’s particular needs. It’s important for spouses to do this together.
For example, if you or your spouse are facing possible layoffs at work, the best place for your tax refund is probably your emergency fund. If you have credit card debt that is adding stress to your budget, using the refund to pay all or part of it might be your wisest choice. If the car is on its last wheels, maybe the tax refund can help you buy a newer one.
If you have little or no debt and are comfortable with your spending and saving habits, you have more leeway to regard a tax refund as discretionary income. You might be able to choose between adding to a retirement fund, saving for college, or taking a family vacation. I would recommend focusing on building a solid emergency reserve and fully funding retirement accounts ahead of putting money into college funds for the kids.
As you and your spouse look at your family’s specific needs and wants, I suggest considering your options for using a tax refund in light of one important question: “Which choice will do the most to increase our financial well-being?”
Once you’ve decided how to use this year’s tax refund, you can increase your financial well-being even further with one more step. Look at how much you pay throughout the year, both in withholding and estimated tax payments. If your tax bill has consistently been less than your payments, or if it is likely to be lower over the next few years, adjust your withholding and estimated tax payments accordingly.
Given the current low interest rates, it may seem pointless to worry about overpaying your taxes. You don’t earn any interest from the government, but you won’t earn much from a bank or credit union, either. Even so, having emergency cash in a savings account that earns even a little bit of interest is a far better option than paying interest on a credit card. Or if you can put that money into an IRA, you may gain some tax benefits.
The bottom line is that a tax refund is not “found” money. It’s your money. It can’t contribute to your family’s financial well-being while it’s tied up on loan to Uncle Sam.