It’s the time of year we dread: tax time. If you’re through the woods and have already filed, you’re likely among the 80% of Americans who will be receiving a refund. The only question now is what to do with it. First, I feel like it’s important to understand that your tax refund is not by any means free money. It means you gave the government an interest-free loan. Shame on you. (Well, actually, shame on us, because I’m right there with you.) So what should we do with the money we receive from taxes? Or any sudden lump sum?
Just like with any form of financial advice, there are a few schools of thought here, and these four options will explain what you can do with any amount of money you receive:
1. Invest your refund.
The investment camp is a good camp to be in. The rate of return, many argue, is higher than what I’m paying to service my debts, so it might be worthwhile to put extra money in investments. I think it makes a lot of sense if you’re actually going to invest it. If you are going to be a member of the investment camp, you may be setting yourself up for early success, and investing money that you didn’t need won’t feel like you sacrificed quite as much as investing money from your regular paycheck. It is also easier than ever to be in the investment camp because there are dozens of ways to open an account and start investing. You can invest by yourself, or seek advice from a professional if you need help determining your risk tolerance and where to put your money. As a financial analyst, if you don’t go through an advisor, I personally recommend investing in low-fee broad market ETFs. They will be your lowest cost option and provide you with a low-risk diversification.
2. Pay off debt with your refund.
You can also be in the pay off debt camp. There is another school of thought that advocates for paying off any debt you can with lump sums. This could include paying off student loans, car loans, or credit card debt. If you are trying to choose which debt to pay off, I recommend going with the debt with the highest interest rate. Use the lump sum bucket of water you got, and put the debt fire out! As much as it’s difficult to accept, debt weighs on your cash flow and can prevent you from saving, investing, or getting ahead. Ask yourself how much you could save if you didn’t have a car payment, student loan payments, or any other debt payments. Using your tax return to pay off your debt could be very beneficial in the long run.
3. Save the money.
This is the camp I’m falling into this year. While it might not be as sexy as investing, this year’s return will fill our emergency fund to the six-month mark, meaning if something terrible happened, my wife and I could live off the emergency fund for six months. If your emergency fund is already taken care of, you could be saving up for a car that you’re going to pay for in cash, or for a down payment on a new home, or simply for your future, even if you’re not quite sure where the future is taking you.
Why are we refilling our emergency fund this year? Because someone stole our car and lit it on fire. That is not a joke, it really happened. But, because we had an emergency fund, we were able to take action quickly. Unfortunately, now, we have to rebuild that fund. If you don’t have an emergency fund, take this opportunity to start one. The average tax refund came in around $3,000 in 2015. Sounds like the start of a really nice emergency fund to me. In our current financial environment, you may think there isn’t much incentive to keeping any money in a savings account. However, there are a few options available: many smaller banks and credit unions are giving savings account rates of more than 1%, and a quick internet search for high-interest savings accounts will provide a number of other options. I’m currently using two accounts that are giving back 6%!
4. Spend your refund (if you must).
The “spend it” camp is an area where it’s important to proceed with caution. If you don’t think you have financial goals right now and that you can just spend your tax refund on the 90-inch screen television you’ve been eyeing, it might be a good idea to slow down. We don’t want to treat our refund like we’ve won the mini-lottery. Splurging on something with your windfall isn’t going to miraculously make your life better. Sure the 90-inch screen will enable you to binge your latest Netflix series from across the street, but is that actually what you need right now?
The only reason “spending” is on this list is because you may have already worked your tax return into your budget. If that’s the case, spend it accordingly to ensure that you don’t fall behind. But in the future, it’s best not to rely on any funds outside of your ordinary salary for spending money. This will keep you from getting into a bind if for some reason you don’t get the lump sum you’re expecting.
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Regan is a new father, a husband, and a financial analyst. He blogs here.