First of all, congratulations on getting a tax refund. This means last year’s tax planning protected you.
For this article, I am assuming the tax refund is net of payments applied to the first quarter estimates and the tax planning for next year is complete. For most people, this will not be an issue, but if you are starting to pay Uncle Sam when filing your taxes, consult a tax professional, they can help you with tax planning.
The next assumption is the tax refund is net of spiritual obligations. All the major religions in the world have some form of tithe or obligation that is paid. Each person’s situation is unique, so the tax refund amounts are assumed to be after the spiritual obligations are addressed.
Another assumption is your retirement account has been taken care of. For most wage earners, the contribution made from your paycheck into your 401K or pension plan will take care of this. If you are self employed, you should be taking care of this as part of managing your business. If you do not have or have not funded your retirement account, the refund should be used for that purpose first.
What you should do with your tax refund will depend on the size of the refund, what your current economic situation is and if you have already made plans for the refund.
The following are just guidelines and should be modified to fit your situation.
The Small Refund
If your refund is small, say $100 or less, then spend it on something fun. You have worked hard all year, treat yourself and your loved ones to dinner out, go bowling, buy a computer game for the kids. Sometimes having an unexpected treat can be therapy for the whole family.
The Medium Refund
The size of this refund is probably the most difficult to deal with. It is not big enough to have a major impact on a bill or purchase, but still big enough to make a difference.
The size will vary depending on your income level. For a single mom, $300 would be a lot of money, while someone who is making $80,000 a year, $300 would be on the smaller side. What is important is that it can make a difference even if it is small.
I suggest you split the refund into thirds and do the following:
The first third should be set aside for “fun”. (You can see a theme developing here.) You should use this to treat yourself and family. This should be done guilt free as you used Uncle Sam’s Bank as your savings account. Celebrate having saved some money!
The next third should go into savings. Unless you have six months of cash available to you, saving some of the refund in an “emergency” fund will help give you some peace of mind. This should be in a place that you can quickly get to.
You should not feel guilty about using it in an emergency or when an unexpected expense arises. A good example would be getting a flat tire. Instead of putting the cost of the tire on a charge card, you could use the emergency savings to pay for it. Having cash available for unexpected expenses can be liberating.
The final third of the tax refund needs to do one of two things. Service debt or add to investing assets.
Depending on your situation, servicing debt could be the most prudent course of action. Reducing credit card debt should be the first priority for everyone. The current interest rates on credit cards is horrendous. Paying an extra 10% to 23% on a purchase every month eats away at your cash flow and limits options. By far, the first priority should be to eliminate any credit card debt.
If you are meeting your monthly obligations out of normal cash flow and credit card debt is gone or at a minimal level, the other option is to start or add to your investing account.
What is an investing account? It is an account you start with the idea of building capital to purchase or invest in income producing assets. This is where you eventually purchase assets that pay you instead of the asset losing value. This is the key to financial wealth.
The Big Refund
The big refund can be a game changer for some and can be a signal tax planning is needed for others. What you don’t want is to have a large refund every year. That means you are overpaying your taxes. By reducing your payments to Uncle Sam, you can use the extra cash flow to reduce debt or increase your investing account.
The first thing you do with the big refund is to have some “fun”. As before, spend some of it on you and your family. Depending on the size of the refund, you may even want to use it for a vacation. For some families, that is what the tax refund is for. It funds some or all of the summer vacation.
The next item to spend at least half of the big refund on is to reduce debt. Target credit cards first then look to see if an auto, boat or personal loan can be reduced or eliminated. Having one less bill to pay every month can be liberating.
Next look to see if you need to fund an emergency savings account. You may only need to have $500 or $1000 set aside.
Finally, with the rest of the monies, start or continue to fund your investment account. After a few years your investment account may be ready to purchase an income producing asset. With a big refund, it may push you over the top an you can start investing in mutual funds or have enough cash to start a stock portfolio.
To summarize, there are many ways to use your tax refund. First, treat yourself and family. Then reduce debt and start funding your investment account. Only you can make the right decision.