A tax refund can be a welcomed boost to your income in the new year and may spark the question, “What should I do with it?”
One of the smartest moves you can make is to use your return to help boost your overall financial health, and there are plenty of ways to do so.
Rank your financial goals by priority
How you use your tax refund should ultimately be determined by the most pressing financial goals in your life.
If paying off debt is high up on your to-do list, it helps to rank your debts by priority. One of the easiest ways to do so is by categorizing each debt as either inefficient or efficient.
Inefficient debt is non-tax deductible and usually carries higher interest rates. This type of debt is used to purchase depreciating items like a car or personal loan. Efficient debt, on the other hand, is tax-deductible and helps you obtain items that gain value over time.
You should first focus on inefficient debt like credit card debt or personal loans, says AnnaMarie Mock, financial planner and wealth advisor at HIGHLAND Financial Advisors.
“Compounding interest will increase your monthly payment quickly because the interest is applied to the original principal and the interest that already accrued,” Mock says.
Option 1: Tackle your credit card debt
As a form of inefficient debt, credit card debt has the potential to lower your credit score, affect your ability to qualify for financial products and overall set you back financially.
If you have credit card debt, using your tax refund to pay it off (or at least make a dent) should be a top priority for you. You can experience numerous benefits from doing so, with the most obvious being reducing the amount you owe and saving money on interest. Paying down debt can also lower your credit utilization ratio, which has the potential to boost your overall credit score.
In the best-case scenario, your tax refund is enough to completely wipe out your credit card debt. But if your refund falls short of your debt payoff needs, consider transferring your balance to a balance transfer credit card. You can then wipe out a portion of your debt with your tax refund and continue to pay off the rest within an introductory zero percent APR window.
Option 2: Start an emergency savings fund
If you fall within the 23 percent of Americans that don’t have emergency savings, why not use a tax refund to start one?
An emergency savings is meant to cover unexpected costs — like medical emergencies or car repairs — and should comprise three to six months worth of income in liquid cash.
Start by depositing your refund in an FDIC insured savings account. You could take it a step further and open a high-yield savings account in order to earn interest on your balance. Going forward, you’ll want to add to your emergency savings at least once a month.
Kyle Goulard, financial planner at Goulard Financial Planning, suggests setting up an automatic transfer from your checking account to your savings that deposits each time you earn a paycheck.
“Start with $50 and see if you feel a difference in your wallet,” says Goulard. “Increase it occasionally until you’ve found a comfortable amount that you can part with on a regular basis.”
Option 3: Pay off student loans
If you have any lingering student loan debt, consider paying down a portion of it (or completely eliminating it) with your tax refund.
Should you have multiple loans, make sure to put your refund towards the loan with the highest interest rate. If you have both private and federal loans, put more of a focus on your private loans (while continuing to make payments on your federal loans). These tend to carry higher interest rates and lack the breadth of repayment options offered by federal loans.
Keep in mind paying off student loans shouldn’t be your top priority if you don’t have emergency savings built up or are sitting in significant credit card debt.
Option 4: Invest in stock(s)
It’s never too late (or early) to begin your investing journey — sometimes, half the battle is setting aside enough money to invest or overcoming a fear of doing so.
Receiving a tax refund — no matter the amount — is an opportunity to invest a chunk of money into whichever companies you believe would benefit you most in the long run.
Apps like Robinhood make it easy to buy and trade stock from the palm of your hand. If you’re more so interested in a set-it-and-forget-it investing method, Bumped automatically awards you for spending at your favorite brands, selected within the Bumped app. (Bumped isn’t fully released to the public yet, but you can sign up for their waitlist, here.)
Going forward: Is a refund right for you?
The question of whether you should strive for a tax refund each year or adjust your tax withholdings to earn more throughout the year is up for debate.
Those who consider themselves less disciplined financially may benefit from earning a tax refund, says Paul Fenner, financial planner and founder of TAMMA Capital.
“Having the government hold onto your money isn’t the worst thing that could happen as long as you have a solid plan for what you would do with the return rather than simply blowing it,” Fenner says.
JP Geisbauer, financial planner and principal at Centerpoint Financial Management LLC, instead suggests reducing the amount the government withholds from your paychecks. In doing so, you receive more with each paycheck and can incorporate that money into your financial plan through the year rather than a lump sum once a year.
“It’ll reduce the refund in the following year, but you will have access to the money sooner,” Geisbauer says.