April’s the season for flowers, sunshine . . . and tax refunds! Those annual checks provide a nice bump to the budget and have been known to inspire many a spontaneous beach trip or shopping spree.
Maybe spring fever has you dreaming about all the fun you could have with a fat refund check. Who doesn’t enjoy a splurge now and then? That’s totally understandable!
But with a bit of planning, did you know your tax refund has the power to pay for much more than a trip to the beach or the mall? Let’s take a look at how you could use those extra dollars to fund a better life for yourself both today and tomorrow.
Bolster That Emergency Fund
How’s your emergency fund feeling these days?
Let’s hope you have at least $1,000 saved up to keep you from borrowing the next time you need a sudden car repair or doctor’s visit. If you don’t, devoting part of your tax refund to your emergency fund is a no-brainer. With the IRS reporting refunds averaging around $2,800*, most people could use their check to knock out Baby Step 1, and probably make progress on other steps as well.
And if you’re already done with Baby Step 2 (paying off all your debt but the house), that’s outstanding! In your case, any extra refund dollars should go toward making your emergency fund so big it can cover you for three to six months of living expenses. Shopping sprees are a lot more fun when you know they aren’t jeopardizing your financial picture in the long run.
Attack Any Debt
As smart as it is to save money, there are times when building up cash isn’t the wisest move. In fact, a new survey from GOBankingRates revealed that 38% of Americans plan to use at least some of their refund to pay off debt.**
Once you’ve placed a solid grand in your emergency fund, it’s time to throw the remainder of your tax refund into paying down debt. To see why, consider how much interest you’ll be paying over the life of most loans. It’s true of car loans, credit cards, school debt and even home mortgages. Depending on the size of the debt, the interest rate, and how fast you’re paying, you can expect to pay thousands of dollars in interest over the life of the loan. The only way to reduce those big interest payments is to get aggressive in paying down the principal.
The benefits you’ll enjoy by being debt-free are not static. Once you’re debt-free, putting money into savings (instead of toward debt payments) gives that money the potential to grow over time through the power of compound interest!
Think About the Future You
Every year, tax refunds seem to come and go. But your financial needs are not going anywhere. In fact, there’s a future you who has needs you don’t even know about yet.
If you’re already debt-free (or if you’re getting a big enough refund to complete Baby Step 2 this year), and also have a full emergency fund, it’s time to give some serious thought to Baby Step 4—investing in your retirement.
Think about it: Over time, any extra dollars you have could work to your benefit through the miracle of compound interest. Let’s use the average return of $2,800 as an example. If you tucked away that amount today in a 401k or similar retirement account, it might not sound like an investment with much potential for your future.
But remember you’re already debt-free and you’ve gotten out in front of life’s emergencies. That means you have some flexibility in your budget. If you could find just $233 every month to contribute toward the same initial investment, compound interest at an average 10% rate of return would expand your investment to a whopping $555,000 in 30 years!
What? All you spent was $86,700 of your own money—a mix of this year’s $2,800 tax refund followed by a small (but smart) habit of monthly contributions—but you picked up a tidy $465,000 in growth! Not bad for a one-time decision to favor the future you.
Keep Using Tax Refunds to Fill in the Gaps
It’s tempting to think of a tax refund as a springtime bonus for a year of hard work. But we all have times when our financial foundations are shakier than others. If you’re living without an emergency fund or struggling with debt, you owe it to yourself (both today and tomorrow) to use extra money to strengthen those areas. Then get in the annual habit of plugging any tax refunds into whatever Baby Step you’re on that year. The sooner you can cover those immediate needs, the sooner you can build the kind of wealth that will make tax refunds seem like small potatoes.
Related: Is it better to get a big refund or less? Log into SmartDollar for more answers to top questions on taxes.
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