Uncle Sam's Ingratitude
When it comes to taxes, most people end up paying more than their fair share throughout the year – only getting them back months later as a refund. How can a refund be a bad thing? Well, a refund is basically the government repaying the principal on a loan from you, sans interest. To put a stop to your unintentional charity, you need to adjust your withholding when your situation changes (you buy a house, you get married, etc.). If, however, you didn't get around to it, we'll look at how to use your tax refund to strengthen your overall financial situation. (See Money Saving Year-End Tax Tips and Common Tax Questions Answered for more on adjusting your filing.)
Destroy Your Debts
Although a new TV or a faster computer might offer more immediate satisfaction than putting your refund toward paying off last year's purchases, the overall benefits of paying down debt are incomparable. By paying down debt, whether credit card, car loan, mortgage, student loan, or any other kind, you are essentially seeing a guaranteed return equal to the interest you would have otherwise paid. $1,000 against a credit card bill can be as good for you financially as a $1,000 investment that appreciates 10-29%. Even doubling up on payments to your mortgage once a year can shorten your overall payment period and interest paid by a significant margin and reduce your chances of succumbing to debt fatigue.
Build A Financial Bunker
If you don't have any outstanding debt to attack, your tax refund might be an excellent starting point for building an emergency fund. When people get into financial dire straights, a lack of liquidity is usually the root of the problem; in other words, you don't get your paycheck until next week, but the mechanic's bill is due now. To guard against this and other situations, it is essential to have a financial buffer, preferably two to three months' expenses, stored in an easily accessible account. (For more insight, see Build Yourself An Emergency Fund).
Shore Up Your Nest Egg
If you're in the enviable position of having no debt and a healthy emergency fund, then you can always look to the future. Your tax refund can provide a healthy boost to your existing retirement savings or help you start saving for retirement if you haven't gotten around to it yet. For those just starting out, there is an alphabet/numerical soup of plans available: 401(k), 403(b), Roth IRA, Traditional IRA, SEPs and so on. (To figure out which one is right for you, see our Introductory Tour Through Retirement Plans.)
Pump Up Your Portfolio
If you want to see returns from your refund while you've still got your original teeth, you might consider throwing it into a shorter term investment portfolio. Investing doesn't have to be exclusively for retirement - it is also a way to see appreciation on capital that can be used to put a down payment on a house, buy a car, pay for college, or for any number of purposes. The purpose and the time frame will help you decide what type of investment you should be looking at. (For more on this, see Investing With a Purpose.)
If you already own your own home, then a double payment on the mortgage may be in order (provided it's allowed under your loan terms). If not, now might be the time to start looking. Whether you are buying a property to live in or as investment real estate, the more money you put into the down payment, the less you will have to borrow. Putting down 20% eliminates the extra cost of PMI, but even the more modest goal of 10% will give you negotiating power with the banks. A tax refund isn't going to pay for your first home or investment property, but every little bit helps. (See Investing In Real Estate and First-Time Home Buyer Guide for more information.)
Put Junior Through College
It is never too early to start saving if you are planning on helping your children with the costs of college. The costs of education have gone up steadily, and the more time your child's college fund has to compound, the better. There are several plans available, including ESA plans and 529 plans. Although saving for college means a financial sacrifice now, it will save your child from having to take on an enormous debt load when he or she graduates. In addition, if you stick your child with the cost and he or she can't handle the loan maintenance, it's often cosigning parents who end up picking up the slack anyway. (See our Guide To Education Savings Accounts for more.)
"An investment in knowledge always pays the best interest." – Benjamin Franklin Why let junior have all the fun? A tax refund could be well used as tuition for your own education. Depending on how you earn your dough, there may be courses providing additional training and certification that can make you more employable and eventually increase your income. Investing in yourself can pay dividends; more avenues open up in good times and you have more job security in bad times. Provided, that is, that the extra training is applicable. (See Investing In Yourself With A College Education for more.)
Play To Your Weaknesses
If you know you're going to do some senseless spending no matter what, there is a way to turn your weakness into a strength. Much like placing a stationary bike in front of the TV, you need to work out a deal with yourself. For every impulse purchase, make an equal contribution to your savings. This way, you can enjoy your refund and still come out ahead. The catch is that this strategy is only as good as your will power - the stationary bike means nothing if you pull the sofa up beside it and use the seat as a snack table. (For more on smart shopping see Five Money-Saving Shopping Tips.)
Prepare For C-Day
An unexpected refund can become an excellent buffer against what should be an expected expense. Christmas comes at the same time every year, but it still catches the majority of people off guard. The sudden spike in spending that accompanies the yuletide season forces many people to resort to consumer credit for gifts. Sometimes this reliance on credit cards extends to covering living expenses for months while overenthusiastic shoppers deal with the financial aftermath of the Christmas splurge. You can store the refund in a money market fund or a Christmas club account to lessen your spending hangover. (See Keep Holiday Debt From Snowballing for more.)
Attaining Financial Security
Although none of these ideas are as exciting as margaritas in Rio or a home theatre system, being smart with your tax refund will strengthen your financial position now and in the future. After all, a tax refund is not a gift from the government that you must spend on a flatscreen TV, but the tardy return of a small portion of your hard-earned money.