A federal tax refund is your overpayment from your paychecks to the government over the previous year. You are giving Uncle Sam an interest-free loan! Ideally, with updated W-4 withholding forms, you would not get a refund. However, if you do receive a refund, it opens many possibilities. In this article, we discuss 10 smart ways to spend your tax refund.
Although it’s not free money, it feels that way. It is money that was not counted in my monthly income and spent on expenses. It’s not part of my regular 50-30-20 budget plan, but it can help address certain areas.
According to CNBC, the average Federal tax refund in 2021 was $2873. Once you have filed your income tax return and received your tax refund, what are you going to do with your windfall? Here are 10 smart ways to spend your tax refund.
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10 Smart Ways to Spend Your Tax Refund
1. Build up your emergency fund
2020 and 2021 were full of financial challenges. Costs rose as some consumer goods were hard to find (toilet paper and flour, anyone?). People in service industries were out of work, and factories and workplaces had to shut down due to COVID-19 outbreaks. Many people had to tap into their emergency funds to get by. Now is the time to put that money back in! Financial experts recommend that you have at least six months of expenses saved in your emergency fund. If you work in a more volatile field, you should aim to have twelve months saved. Your goal should be to cover unexpected expenses like car repairs, medical bills, and other unplanned emergencies.
2. Pay off credit card debt
The 2nd smart way to spend your tax refund is to pay off credit car debt. It doesn’t make much sense to put money into even a high-yield savings account at today’s low rate of return while paying high-interest rates on credit card debt, even if they are rewards credit cards. A tax return can put a hefty dent in that debt, freeing up money for other bills or investments. If you have multiple cards with balances, pay off the highest interest rate card first. Evaluate your spending to make sure you aren’t using credit cards to live beyond your means. If you can’t pay for it today, you shouldn’t be charging it towards your tomorrow!
3. Add to your retirement account
Take your refund and stash it in your Roth IRA or traditional IRA account. According to the IRS, in 2021, the IRA limit amount increased to $6,000. If you are 50 or older, you can add an additional $1,000, for a total of $7,000. Note that these contribution limits are per person. For instance, you can’t add $7,000 to a Roth IRA and $7,000 to a traditional IRA. You can, however, split the money between the two types of accounts. Have a 401(k) through your employer? Make sure you maximize any matching offered by your company. In 2021 you could contribute a maximum of $19,500 to your account, not including employer matching funds. But if you are 50 or older, you can make catch-up contributions up to $6,500, for a total of $26,000.
4. Fund a 529 college plan
A 529 college plan, named after the IRS code that created it, is a savings and investment account where money can grow tax-free as long as the funds go towards qualified educational expenses. 529 plans are usually operated by states, although you can choose any plan you want, even outside your home state. The plans come in two forms: 529 college savings plans and 529 prepaid plans. 529 college savings plans allow funds to be used tax-free to pay for tuition, room and board, and school supplies such as textbooks. 529 prepaid plans let you buy tomorrow’s education at today’s rates, locking in pricing at the time of payment for in-state schools. Setting up a 529 college saving account for your child or grandchild is an excellent step towards financing a college education’s high cost. The money is invested until it is needed for college costs. Investment is frequently made according to age – riskier investments while the child is younger, stable investments when they are closer to college age. The great thing about 529 accounts is the funds can be rolled over to another child’s education costs if they are not needed for the original student.
5. Invest in your career
The 5th smart way to spend your tax refund is invest in your career. Been wanting to take a class to help advance your career? Now is the perfect time to take your job to the next level. Online education is affordable, accessible, and widely accepted by employers. You may even be able to use the costs of the courses to take money off your next year’s taxes by taking advantage of Lifetime Learning Credit. To claim this credit, you must pay qualified education expenses for higher education for an eligible student at an eligible educational institution, and the student must be listed on your tax return. The eligible student could be yourself or a dependent. Classes, certificates, and degrees all count towards the Lifetime Learning credit. You do not have to be working towards a degree. Courses to acquire or improve job skills are included. The credit is worth $2,000 and there is no limit on the number of years you can claim it.
6. Make extra mortgage payments
Since so much of your mortgage payment goes to interest over the life of the loan, making extra payments towards the principal can make a big difference. Just one additional payment a year can knock a significant amount off your mortgage, especially if it is in the early years of your mortgage where most of your payments are going towards interest and not principal. Making extra payments is one strategy you can use to pay your mortgage off early.
7. Improve your home
The 7th smart way to spend you tax refund is to improve your home. Take your refund and improve your home’s energy efficiency to save even more money in the long run. Upgrade windows to help with heating and cooling costs. Save on your electric bill long-term by buying Energy Star rated appliances to replace older models. Careful updates of kitchens and bathrooms can significantly increase the value of your home when it is time to sell.
8. Buy life insurance
If you are older, with no dependents and little debt, life insurance is probably not needed. However, if you are younger with dependent children, who will take care of them if the unthinkable happens? Term life insurance is an affordable purchase to make with your tax return. Policy prices vary according to age, health, and lifestyle, so be sure to shop around.
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10. Plan some fun
You work hard and deserve some rewards, especially after the last year. Just don’t fritter away your refund with minor purchases, here and there. Make a plan and make it count. Your planned purchase could be a nice vacation, large screen television, or a new computer. Don’t feel like you have to spend it all! You can always save some of the refund for future wants and needs.
Final Thoughts on 10 Smart Ways to Spend Your Tax Refund
All of the above suggestions for managing your big tax refund may not pertain to your situation. Hopefully, some of them will appeal to you and help you create financial breathing room. My suggestion is to be deliberate however you decide to use the refund. Getting a tax refund and using it wisely can help you reach long-term financial goals. And yes, it is fine to plan a vacation when we can finally all travel again.
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Christine Seaver is a freelance writer that writes about personal finance, budgeting, and debt. She is a frequent contributor at Dividendpower.org. Christine works as an office manager by day and a cookie baker at night. She lives in Massachusetts with her family.