A tax refund is the perfect opportunity to improve your finances. In fact, for millions of Americans it’s the only shot they get at a lump sum of cash in most years.
But this isn’t found money. These are real funds that you’ve been actively saving, so you’ll want to carefully choose what you do with the money.
“It’s easy to feel like your tax refund is free money, but while you may have forgotten about it, it’s definitely something that you’ve earned,” says Cynthia Flannigan, a certified financial planner at MainStreet Financial Planning. “So, you should spend it with purpose to achieve your goals.”
These goals should primarily relate to either saving, investing or attacking debt.
5 smart ways to put your tax refund to work
Since this windfall can make a big difference in your finances in 2021, here are five smart options for using your tax refund.
1. Boost your emergency savings
There’s some debate which should be done first – paying off high-interest debt or having an emergency fund. At least starting an emergency fund should be a top priority — and then the rest can be applied toward debt or other priorities.
To achieve financial security, you need to plan for unexpected events. A recent Bankrate survey found fewer than 40 percent of Americans would be able to pay an unexpected $1,000 expense from their savings account. So, setting up (or boosting) an emergency savings account needs to be a key part of your financial plan.
“That way you cover any ‘what ifs’ or anything that could potentially derail your budget and get you further into debt,” Flannigan says.
If you put that average refund of $2,967 in a high-yield savings account or a money market account that yields 0.5 percent annual percentage yield (APY), you’d grow your savings about $15 after a year.
That’s why, if you’re going to put your money into savings, make sure you’re putting it in an account that’s going to earn the most interest. Comparatively, if you were getting the national average savings yield of 0.07 percent APY, you’d only earn about $2 after a year.
In five years that starts adding up — or not. Assuming the variable APYs stayed the same, you’d earn around $65 more in the higher-yielding account over that period.
“We recommend an online, high-yield savings account — so that it’s far enough away from your regular spending that you won’t tap into it, but it’s there if you need it,” Flannigan says.
Savings accounts aren’t meant to be active transaction accounts. If you do want the ability to write a limited number of checks from a savings account, you can find a money market account with a competitive APY and check-writing privileges. Some money market accounts don’t have check writing privileges, so if this is an important feature to you — find out whether it’s offered before opening the account.
2. Contribute to an IRA
An IRA may be the gift that keeps on giving.
In the event you’ve already filed, it’s too late to contribute to an IRA for the 2020 tax year unless you want to file an amended return. (You have until April 15 to contribute to an IRA for the 2020 tax year.) But you can take your refund and put it into a traditional IRA for this tax year, plus what’s in the account can compound tax-free until you withdraw it. The contribution may reduce your 2020 taxable income.
If you’re eligible to contribute to an IRA, make sure that you’re aware of the contribution limits. An IRA contribution can help you boost your retirement balance – and may be a good option, especially if you have sufficient emergency savings, don’t have credit card debt or similar at a high APR and you’ve maximized your 401(k) contributions.
Need to find a brokerage to open an IRA or other account? We’ve got you covered with Bankrate’s broker reviews.
3. Pay off debt
The average APR on variable-rate credit cards is 15.99 percent, according to Bankrate data. Using your tax refund to pay off high-interest debt could be the best use for the money. The average balance on credit cards was $5,315, according to Experian data from November 2020. If you paid only $100 per month on this balance it would take 94 months to pay off and cost you $3,990 in interest, according to Bankrate’s Credit Card Payoff Calculator.
“That’s the most expensive and worst kind of debt, typically,” says Liz Landau, a certified financial planner in White Plains, New York. “So that’s usually the first thing I’ll suggest with a refund.”
Flannigan says there are two ways to approach paying off debt:
- Avalanche method: Focus on paying off the debt with the highest interest. Once that is paid off, move on to the balance with the next-highest interest. You save the most money this way.
- Snowball method: Pay off the smallest balance first for the sense of accomplishment, and then work your way up until you finish.
4. Contribute to a savings account – to save for key goals
If you already have an emergency fund and you’ve either applied money toward debt or don’t have any debt, then put at least some of your tax refund into a high-yield savings account. It could be money that’s earmarked for a down payment on a home, a wedding or saving for a vacation.
“I would sweep that whole refund into saving towards whichever goal is the next priority,” Landau says. “Don’t let it hit your checking account. Sweep it right out.”
You don’t have to earmark a savings account now. Your life goals will probably change as you age. So just having that money in your savings account will allow you to easily adapt as priorities shift. You can either lump all your savings into a single account or place funds in separate high-yield savings accounts to make sure that money meant for one purpose doesn’t get casually used for something else.
In the old days, banks offered tiered balances to encourage you to put all your money at a single institution to get the highest APY. But now online banks, generally, offer the best APYs and require low or no minimum balance in return. There are several accounts with competitive yields that have no or low minimum balance requirements.
5. Deposit some of your tax refund into a CD
If you want to put your tax refund toward a longer-term savings goal, consider a certificate of deposit.
In this current rate environment, it probably makes sense to stick with the shortest-term maturity that’s going to give you the highest APY for the shortest duration. Or you can also consider laddering your CDs by spreading the money between CDs with different maturity dates. Laddering CDs may help you avoid early withdrawal fees and get a higher APY on longer-term CDs. Always consider what the money is being earmarked for before depositing it into a CD.
Current APYs on CDs can help you earn potentially more than you would in a liquid account, such as a savings account or a money market account. But if you withdraw from a CD early, you may incur an early withdrawal penalty, typically about 90 to 270 days’ worth of interest on a one-year CD.
Looking toward the future
Don’t feel like you have to put all of your tax refund toward debt or all toward an emergency savings plan. Feel free to split it multiple ways.
“Ultimately, you have to ask yourself what’ll make you feel better in the long run,” Flannigan says.
If in the future you’d like a smaller refund, Flannigan says you could increase your withholding allowances.
“So, less income tax will be withheld, your refund will be smaller, but your monthly paycheck will be larger and you’ll be able to spend that money on your goals instead,” she says.
Or you can think of your tax refund like it’s forced savings.