Depending on your financial situation, a big tax windfall can have a major impact on your financial well-being. But the question every refund recipient faces is what you should do with that cash. Here are seven possibilities.
You’ll have more time to file this year – due to the coronavirus outbreak, the IRS has extended the tax deadline to May 17.
According to the IRS, as of March 26, 2021, roughly 56.5 million taxpayers received a refund for 2021 so far, with an average haul of $2,902. Depending on your financial situation, that kind of windfall can have a major impact. But the question every refund recipient faces is what you should do with that cash.
Millions of Americans have joined the ranks of the unemployed due to the COVID-19 outbreak. Many will likely use their tax refunds, as well as federal stimulus checks, to tide them over until they can get back to work.
See related: Is credit card interest tax deductible?
7 ways to use your tax refund
1. Boost your emergency fund
According to a survey by CreditCards.com, 28% of Americans who expect to receive a tax refund plan to save it — the most popular answer in the survey. While there are many different ways you can save money, the most pressing for many people is to create or beef up your emergency fund.
Financial experts generally recommend keeping three to six months’ worth of expenses in a savings account for emergencies. A few thousand dollars may not be enough to achieve that goal, but it’s a good start.
“Travel hiccups, medical emergencies and home repairs or vet visits are unpredictable,” says consumer finance expert Andrea Woroch, “and savings can give you the peace of mind that you can get through these tough financial times without going into debt.”
2. Pay down high-interest debt
Roughly a quarter of Americans plan to pay down debt with their tax refunds, but it’s important to keep in mind that not all debt is created equal.
“I’d look to pay down high-interest debt first,” says Mark Wilson, a CFP and president of MILE Wealth Management. That may include credit cards, personal loans and some student loans.
If you’re wondering which debts are considered high interest, think about it in terms of the opportunity cost. If you were to invest the money in the stock market, for instance, an investment advisor may tell you to expect a return of 6% or 7% over the long term, to be conservative.
If you have debt with an interest rate that’s higher than that, pay it off first because you’ll likely get a better return in the form of interest savings than you would in the market.
“I would not likely recommend paying down mortgage debt,” Wilson adds, “as this is often low-interest and deductible debt.”
Despite drastic rate cuts by the Fed, the average credit card APR is above 16% as of April 1. And a 2021 CreditCards.com survey showed millions of Americans accrued more debt during the COVID-19 outbreak.
3. Invest in the future
If you already have a robust emergency fund and no high-interest debt, consider investing some or all of the cash for retirement or some other future goal. You can contribute to an individual retirement account (IRA) and receive some tax advantages or sock the money away in a taxable brokerage account, which won’t penalize you for withdrawing cash before you reach retirement age.
Alternatively, if you have one or more children, you may consider putting some money aside in a 529 Plan or Coverdell Education Savings Account for future college expenses.
Before you take this step, though, make sure your own future is in good shape.
“You should not be sacrificing your own retirement in order to pay for college,” says Allison Bishop, a CPA and financial coach based in Portland, Maine. “Retirement comes first, before most other savings priorities, excluding some emergency savings or possibly a down payment for a house or investment property.”
4. Invest in yourself
Investing in the future doesn’t necessarily have to involve an investment account.
“You are your own greatest asset, and investing in yourself thoughtfully can help boost your earning potential,” says Woroch.
Woroch recommends looking for different ways to improve your skills, or even gain new ones, through workshops, seminars, conferences, mastermind groups or networking events. Although any event that requires people to travel or gather in groups is currently on hold, you may still find helpful resources and virtual networking events online.
Alternatively, you may choose to use your tax refund to start a new business that could allow you to become your own boss, do something you love and improve your financial well-being.
5. Spruce up your home
If you have some major appliances that need to be replaced or other home improvements you’ve wanted to make, your tax refund can help you get started. If you have a lot of renovations or repairs you want to make, prioritize them based on how big your refund is and the costs associated with each improvement.
Also, keep in mind that some renovations provide a better return on investment than others. According to Bankrate, the top improvements with the best return on investment include garage door replacement, manufactured stone veneer, minor kitchen remodel, deck addition and siding replacement.
See related: Best credit cards for home improvements
6. Buy a new (to you) car
For many Americans, their car is their primary form of transportation, so it’s essential to have a reliable vehicle to get to work, school and other necessary activities. If your car has some mechanical issues that could make these things difficult, buying a new one could be considered a form of risk management, and it could also save you money on future repairs.
Keep in mind, though, that if you have a loan on your existing vehicle, you’ll need to get enough money from selling it to pay off what you owe. Trading in the vehicle at the dealership is more convenient, but if you have the time, consider selling it to a private party instead to get more money.
7. Donate to charity
If your financial situation is in good shape, consider giving some of your tax refund money to a worthy charitable organization. According to researchers, charitable giving can improve the emotional and mental well-being of the giver.
If you’re thinking about going this route, use services like Charity Navigator to find and vet nonprofit organizations. You’ll get a glimpse into how your favorite charities spend their money, so you can make as meaningful an impact as possible with yours. The site has a dedicated coronavirus section if you want to contribute to COVID-19 relief efforts.
See related: 1099-C surprise: Canceled debt often taxable as income
Consider whether you want big refunds in the future
Getting a tax refund every year can feel like a nice gift, but it does mean that you don’t have access to that money throughout the year when you could.
“I have mixed feelings about tax refunds,” says Wilson. “They obviously feel like free money, yet they mean someone lent their money to Uncle Sam for too long, for free.”
The good news is that it’s possible to estimate how much tax you’ll owe based on your wages on the IRS website. Doing this can help you determine whether you should reduce how much is withheld from your paycheck.
While it sounds complicated – you’ll need to contact your payroll manager to request a lower tax withholding amount – it’s important to consider if you have financial goals and don’t want to wait until you get your refund every year to work toward them. It’s especially important if you have high-interest debt, says Bishop.
“For a W-2 employee, if you reduce your withholdings and put that extra money every pay period directly toward your debt,” she says, “you’ll be much better off financially over the course of a year than accumulating a large tax refund and putting that lump sum toward your debt.”
Ultimately, what you choose to do with your tax refund – or whether you decide to get that money once a year or throughout the year via reduced withholdings – is up to you. But these tips can help you get an idea of options that can help you achieve your financial goals and improve your financial and overall well-being.