Even when we expect our tax returns to bring a refund, we all dread preparing for the tax deadline. The arcane tax forms, instructions few can decipher, and our increasingly complex financial situations make each year's return seem more painful.
Many personal finance experts recommend adjusting your withholding—the amount your employer withholds from your paycheck—so you don't get a refund at all in the spring, arguing that this amounts to giving Uncle Sam an interest-free loan for several months when you could be putting that money to immediate use. For some people, though, having the government hold their money is the easiest way to accomplish their savings goals. If you don't have a plan for that refund check, it could be all too easy to spend it.
Instead of succumbing to impulse, consider these five options for letting the savings you accumulated last year bring you greater financial security in the years to come.
1. Pay Down Debt
When the balance you owe to credit card companies goes down, the interest or finance charges you have to pay on that debt also drops. And according to the Federal Reserve Bank of St. Louis, the average interest rate on a credit card was 16.88% in November 2019. Depending on your interest rate, you save 10% to 29% per year in interest on any portion of your balance that you manage to wipe out.
Simply using your refund to pay off an extra $1,000 of debt this year could save you hundreds of dollars in future finance charges.
2. Fund Emergency Savings
If you're among those fortunates without credit card or other high-interest debt, put yourself in a stronger position to stay that way by putting your refund check into an emergency-fund savings account. You have many different options available to you, whether opening an account at a brick-and-mortar financial institution or with one of the many online savings banks. Many of them offer competitive interest rates on savings accounts.
This special savings account will allow you to cover expenses in case of an emergency, whether you're laid off from work or you face unexpected medical bills. Instead of borrowing money from credit card companies at high rates or paying interest and penalties on a loan from your 401(k), you can use a well-funded emergency savings account without jeopardizing your credit score or your retirement.
The general consensus is that most people need the equivalent of at least three months' salary in an emergency fund. Don't let that deter you from saving more.
3. Save for Retirement
If your credit card debt is non-existent and you've got several months' living expenses saved, consider yourself ahead of the pack. To strengthen your financial position even further, consider putting your tax refund into an individual retirement account (IRA).
There are two different kinds of IRAs: traditional and Roth IRAs. If you don't already have one, use this opportunity to start one. As long as you meet certain income requirements as defined by the Internal Revenue Service (IRS), you're entitled to open a Roth IRA even if you already have a 401(k), 403(b), or another employer-sponsored retirement plan.
Before you do, know your contribution limits. The IRS increased the contribution limit for 401(k)s for the 2020 tax year to $19,500, up from $19,000 the previous year. Catch-up contributions for those older than 50 also increased to $6,500, from $6,000. Contribution limits for both traditional and Roth IRAs cannot exceed $6,000 ($7,000 for those age 50 and over.
4. Invest in Real Estate
If you don't own your own home yet but would like to in the future, now is the time to start working toward that goal. Mortgages are still close to historically low rates and in some regions, depressed housing prices make this a good time to buy.
If you already have a mortgage, paying off your principal balance early can help you save money in interest. Check with your mortgage lender to see which early payoff options are available under your loan terms.
5. Start a College Savings Fund
It's never too early to start saving for your children's tuition. The earlier you start, the less you'll need to save because compound interest and time do much of the work for you. If you happen to save up four years' worth of tuition early, you can always start putting your extra money toward college funds for books, computers, and other school-related expenses.
One familiar tuition-savings plan, a 529, has been expanded. Under the Tax Cuts and Jobs Act (TCJA) of 2017, plan holders can withdraw from their 529 to pay for the annual tuition of a beneficiary's public, private, or religious school K to 12 education. And after the SECURE Act (Setting Every Community Up for Retirement Enhancement) of 2019 became law, as much as $10,000 per student can be withdrawn to pay down qualified education debt. Plan holders can also pay for the expenses related to a beneficiary's apprenticeship program.
Not all 529 plans are the same, so you'll want to do some research to see which would be the best for your family.
Another option is a Coverdell Education Savings Account (ESA). This tax-deferred account will help you accelerate your savings.
The Bottom Line
True, none of these five options is as enticing as buying a large flat-screen TV, remodeling your kitchen. or cruising to Hawaii. But using a refund to give yourself financial security can pay dividends far beyond a single tax year.