For millions of Americans, the biggest incentive to complete their tax returns every spring is the prospect of getting a large sum of money at the end of the process.
Averaging $3,100 this year, the tax refund is an important source of income for many households, bigger than any paycheck for most people. According to financial advisors, a lump sum can be an opportunity to achieve financial goals, such as paying off debt, creating an emergency fund, or even saving for a down payment.
Here’s what personal finance professionals are saying about spending that money wisely.
Consider your financial needs first
Before spending this refund, briefly assess your personal situation to determine what is most urgent.
“The #1 question people should be asking is what do they absolutely need to finance right now,” said Max Pashman, a California-based Certified Financial Planner. “The problem I often see is that people get a lump sum and try to figure it out later. The end result is a shopping spree or a purchase they might regret later.”
When assessing your financial needs, think about what is urgent. Have you deferred bill payments? Is credit card debt messing up your budget? Or maybe you’ve been waiting for a major purchase like an appliance or professional certification.
Usually, experts advise a combination of paying off debt and investing your repayment.
“If a problem is preventing you from achieving your goals, this is a great opportunity to attack it,” Pashman said.
1. Pay off your credit cards
Once necessities such as housing, transportation, utilities, and food have been paid for, debt repayment should be the next priority. Try eliminating high-interest debt first, like credit cards or personal loans, say financial planners.
“If you keep a balance from month to month, this should be one of your top priorities for spending extra money on it – it would be hard to beat that ROI!” financial adviser Sam Lewis, founder of SJL Financial, said in an email.
The average APR on a credit card today is between 19% and 20%, which means that paying off a balance will instantly give you a proportional return.
Maggie Klokkenga, a certified financial planner specializing in debt reduction, advises her clients to try to eliminate just one debt rather than tackling them all at once.
“A lot of people have multiple credit cards. If there’s a balance that you might just be able to pay off or pay off a hefty amount, that’s a huge mental win. It really gives them that impetus to say, ‘Look. what I just did – I can do more,” she said.
2. Pay off other debts
If you’re trying to tackle multiple debts with your repayment, focus on those that are affecting your credit score, such as an overdue credit card, auto loans or utility bills, Klokkenga advised.
Medical debt, while a burden for many Americans, will soon no longer affect your credit score, she noted. So while people with healthcare-related debt should try to arrange a payment plan with the provider, “medical debt is usually at the bottom of the pile,” she said.
3. Build up a financial cushion
After paying off expensive debt, consider seeing if you have enough money to deal with unpleasant financial surprises, such as job loss or a car accident.
Polls show that most Americans lack any sort of rainy day fun. More than half the country would not be able to cover a $1,000 emergency, Bankrate found in January.
A tax refund can be a great way to jump-start that emergency fund, which can keep you from going into debt later.
“When you’re faced with unexpected emergencies, you don’t want to rely on high-interest credit cards, interrupt growing investments, or plunder your tax-protected retirement accounts to douse the fire,” he said. John Pak, a certified financial planner based in Los Angeles. .
4. Prepay your pension or insurance
If your debt and bank accounts are in good shape, see if you can use your repayment for your retirement, said William Nunn, a CFP based in New Orleans.
“It puts your money to work for the rest of the year right now, instead of having to wait every payday,” Nunn said.
Making a lump sum contribution is easy to do with an IRA or a Roth IRA. Be sure to stay within boundaries — this year, workers under 50 can contribute up to $6,000.
For workers with employer-based accountsLike a 401(k) plan, there’s always room to increase contributions sooner, Nunn said. Most plans will give you the option to adjust the portion of your salary that you put into your plan. Push that number higher by any amount equal to your tax refund.
If you have life or home insurance, paying a year’s worth of premiums up front could save you money. Most policies charge policyholders for spreading premium payments, which is about 6% more per year, according to Nunn.
5. Pay off your car loan
Car owners with high monthly payments but a low balance on the loan used to finance the vehicle should consider using their repayment to pay it off faster, Nunn said.
“It’s not going to calculate a new payment…but you’ll be done with the loan faster,” he said.
For example, if you have a monthly payment of $500 and you owe $10,000 on your car, paying the full $3,500 repayment toward the balance would reduce nine months’ worth of term of the loan.
“If you know it’s a car you’re going to keep for a while, it might be worth it, especially since it puts $500 a month in your pocket to do other things,” said he declared.
6. Invest in stocks
“If the fundamentals of your financial life are in order – that is, you have an adequate emergency fund, little to no consumer debt, actively saving in a 401(k) or other retirement plan – so consider investing in a taxable brokerage account,” Jason Dell’Acqua, president of Crest Wealth Advisors, told CBS MoneyWatch. “If you have a long-term investment horizon, then recent market declines may work to your advantage.”
In fact, investing your refund can help protect you against inflation, which is over 8% this year.
“With inflation hitting 40-year highs, there’s a very high probability that most of us will lose purchasing power by keeping money in a bank account,” Pak said.
“[B]Given today’s volatile stock and bond markets, investing seems daunting. However, to hold or beat inflation, equities have always been the proven vehicle of choice,” he added.
7. Buy I-bonds
Soaring inflation is making a somewhat obscure investment vehicle much more popular. Several financial professionals have recommended that taxpayers look into Series I bonds, which are US government bonds whose rate of return is indexed to inflation.
“Savings Bonds I adjust for inflation and the new May series annualizes a 9.6% return, which is higher than most stock returns,” noted Jay Lee, a CFP based in New Jersey.
It’s easy to buy bonds directly from the US Treasury. Generally, investors are limited to purchasing $10,000 of I bonds electronically in any given year. However, if you direct your tax refund to I bonds, you can buy an additional $5,000 in paper bonds, Pak noted.
“The window to buy paper bonds is slim. You will need to complete IRS Form 8888 when you file your taxes,” he said. “If you can hold it for five years there is no penalty, but if you hold it for less than five years you lose the interest for the previous three months.”
