Is paying off debt the best use of your tax refund?
5 min read
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Your tax refund could be the biggest windfall you receive this year, but you should remember this sum isn’t “free money” at all.
The cash you get back at tax time is nothing more than the difference between what you paid in and how much tax liability you have in any given year. With that in mind, it might make sense to think of your refund as savings you’ve accumulated, instead of money you can use to splurge.
How much will you get back this year? That depends entirely on your financial situation, which tax credits you qualify for and how much money was withheld from your paychecks each month (or how much you paid in quarterly taxes, if you’re self-employed). If past years are any indication, however, you might receive a few thousand bucks; the average federal tax refund for the 2019 tax filing season was $2,869 as of December 2019.
Can you use your tax refund to pay off credit card debt?
Using your tax refund to pay for a family vacation to the Bahamas, put down some cash on a new car or update your living room furniture can be tempting, and we all know retailers spend big money trying to lure you into spending this time of year. But there are better ways to use your tax refund, and that’s especially true if you’re in debt.
According to a recent survey from CreditCards.com, 24 percent of Americans who expect to get a tax refund this year plan to use it to pay down their debt balances. Paying debt was the second most common response among survey respondents, after saving the refund money (31 percent).
That’s a lot of money to fork over for no reason, especially if you could use your tax refund to pay that debt down — or even pay it all off for good.
Benefits of using tax refund to pay off debt
The reality is, you’ll find plenty of upsides when it comes to using your tax refund to pay down debt, but very few downsides. Really, the only major “pitfall” of using your refund to pay down debt is the fact you can’t spend it on something else you want.
Need more convincing on the merits of using your tax refund to reduce what you owe? Here are the major benefits you can look forward to with this strategy.
Get out of debt faster
If your tax refund isn’t enough to pay down all your debt, this sum can still help you get out of debt faster. Remember that any payments you make above and beyond the minimum payments on your debts will be applied directly to the balances you owe. This means you’ll automatically see a smaller balance once you funnel your refund toward your credit card bills and other debts.
If you’re expecting a windfall of tax refund money, think of the different ways you could use it to your advantage.
Consider transferring your debt to a balance transfer credit card that offers an introductory zero percent interest period. You can use the balance transfer to stall interest accumulation and funnel the cash from your refund directly towards your principal balance, eliminating your debt more quickly.
Find a card with transfer terms and an intro period (many vary between, 12, 15 or 18 months but can last as long as 21 months) that works best with your ability to pay each month so that, with the help of your tax refund upfront, you can pay off the entire balance in full by the time interest begins to accrue again.
If a balance transfer isn’t the right choice for you, you could also consider the debt snowball method, which guides you to pay as much as you can toward your smallest debt while paying the minimum payments on the rest. From there, the plan is to pay down the smallest debts you have first, one by one. As you pay down each of your smallest debts, you’re expected to “snowball” those payments into the next smallest debt until all your debts are gone.
If you use your tax refund to execute the debt snowball, it’s possible you could wipe out your smallest debt right away — or even several small debts in one fell swoop.
Save money on interest
Paying off debt also comes with the financial benefit of reducing balances that accrue interest. Whether you’re able to use your tax refund to pay off all your debt or only part of what you owe, the interest savings can be significant — especially when your interest rate is high.
Let’s return to our example from earlier, in which you owe the average of $4,192 on a credit card with an APR of 17 percent. If you forked over the average tax refund amount of $2,869 right away and kept making a monthly payment of $125, you could pay off your debt in 12 months instead of 46 months. Over that one-year timeline, you would also pay just $121 in interest.
Boost your credit score
Since a large part of your credit score (30 percent) is determined by your credit utilization — how much you owe in relation to your credit limit — paying off debt is one of the easiest ways to improve your credit score in a short amount of time. This is mainly due to the fact that reducing the amount of money you owe without reducing your credit limits will automatically reduce your credit utilization.
Imagine for a moment that you carry $5,000 in credit card balances on several cards with a collective credit limit of $10,000. This means your overall credit utilization is 50 percent, which is fairly high. If you were able to throw $3,000 toward your balances right away, on the other hand, your credit utilization would automatically drop to 20 percent. Since most experts suggest keeping your utilization below 30 percent for the best results, it’s easy to see how this one move could boost your score in a hurry.
Other financially savvy ways to use your tax refund
If you have some debt to pay off but expect to have money leftover, there are plenty of other smart ways to use your refund.
Many people rely on the windfall they receive from a tax refund to sustain their financial goals throughout the year. In fact, the majority of respondents in the same CreditCards.com survey are depending on their expected refund cash windfall: 68 percent of respondents say their financial well-being depends on the money they expect to be returned to them.
Consider these strategies that can help you utilize your tax refund to its full potential:
Add to your emergency fund
Most financial experts suggest keeping an emergency fund stocked with 3 to 6 months of expenses just in case you face a loss in income, a major repair bill or an unexpected medical condition. Consider adding part of your tax refund to your emergency savings, which you should be keeping in a high-yield savings account. While you can hope you’ll never need this money, having a fully stocked emergency fund can give you peace of mind and help you avoid getting into more debt later on.
Contribute to a Roth IRA
You can also consider adding money to a Roth IRA, which is a perfect use for your tax refund since you fund these accounts with after-tax dollars. Best of all, money contributed to a Roth IRA grows tax-free and you won’t have to pay income taxes on distributions once you are aged 59 ½. Note that income limits govern who can contribute to a Roth IRA, and that if you earn more than $206,000 and are married filing jointly (or earn more than $139,000 as a single tax filer), you cannot contribute to a Roth IRA at all in 2020.
Make an extra payment toward your mortgage
Even if your interest rate is low, you can make a considerable amount of progress toward paying your home off early just by making a single extra payment each year. If you go this route, make sure to clearly explain you want your additional payment allocated to the principal of your balance instead of toward your next month’s mortgage payment or your escrow account.