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 than the last. Many personal finance experts recommend adjusting your withholding—this is the amount your employer withholds from your paycheck—so that you don't get a refund check 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. However, for some people, having the government hold their money for them is the easiest way to accomplish their savings goals.
But wait! If you don't have a plan for the money when that refund check comes, 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 and peace of mind in the years to come.
- Use your tax refund to pay down credit cards and other high-interest debt.
- If you are debt-free, consider putting your refund into an emergency savings account.
- Another option is to put your money into a retirement account—a 401(k), or a traditional or Roth IRA.
- Save up for or pay off part of your mortgage.
- Tax refunds are a great way to save for your child's education.
Pay Down Debt
If you have high-interest credit card debt, using your tax refund to pay it off will likely give you greater returns than any other option. That's because when the balance you owe to credit card companies goes down, the interest or finance charges you have to pay on that debt also goes down. 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'll be saving anywhere from 10% to 29% per year in interest on any portion of your balance that you manage to wipe out. The simple act of using your refund to pay off an extra $1,000 of debt this year could save you hundreds of dollars in future finance charges.
Fund Your Emergency Savings
If you're among those fortunate people who don't have any 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 savings account. If you don't have one, now is probably the best time to open one. You have many different options available to you, whether that's opening an account at your own 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 any expenses in case of an emergency whether you're laid off from work or if you're facing 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), a well-funded emergency savings account will put you in a position to lend yourself the money for free without jeopardizing your credit score or your retirement.
So just how much should you save? The general consensus is that most people need the equivalent of at least three months' salary in an emergency fund to feel comfortable. But don't let that deter you from saving more. It's a good idea to sock away more if you can manage it.
The average person needs the equivalent of at least three months' salary in an emergency fund.
Save for Retirement
If your credit card debt is non-existent and you've got several months' worth of living expenses saved up, 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 or Roth IRAs. If you don't already have one established, why not 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, make sure you know your contribution limits. The IRS increased the contribution limit for 401(k)s for the 2020 tax year to $19,500 from $19,000 for the previous year. Catch-up contributions for people 50 and over also increased to $6,500 from $6,000. Contribution limits for both traditional and Roth IRAs cannot exceed $6,000 or $7,000 for people 50 and over.
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. Having learned the lessons of the housing bubble, many potential homebuyers will be in a great position over the next few years to take advantage of depressed housing prices and non-predatory loans.
But 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 what early payoff options are available under your loan terms.
Start a College Savings Fund
It's never too early to start saving for your children's tuition bills. 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.
A common tuition savings plan, called a 529 plan, allows you to prepay qualified higher education expenses at eligible institutions. The rules for 529 plans have been expanded since the passing of two bills. Since the passing of the Tax Cuts and Jobs Act (TCJA) of 2017, plan holders can withdraw from their 529 plans 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 was signed into law, as much as $10,000 can be withdrawn to pay down the qualified education debt per student. 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 fit 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
While none of these options is as glamorous as purchasing a flat-screen TV, remodeling your kitchen, or cruising to Hawaii, giving yourself the kind of financial security that lets you breathe easy even in times of crisis will provide you with a cool composure that never goes out of style.