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For millions of consumers, a tax refund is the only lump sum of cash they get in most years and presents an ideal opportunity to improve their finances.
The average tax refund this year is $2,201 as of Feb. 4, according to the IRS.
A refund, however, isn’t found money and should be utilized carefully.
“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.”
And though the idea of spending it may be tempting, the best use of your refund is boosting your savings, investing or reducing debt.
5 smart ways to put your tax refund to work
A financial windfall is an opportunity to improve your finances. 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.
Achieving financial security requires planning for unexpected events. A recent Bankrate survey found less than 40 percent of Americans could pay an unexpected $1,000 expense from a savings account. So, setting up (or boosting) an emergency savings account is a key part of a smart 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.
The average $2,800 refund put into a high-yield savings account or a money market account that yields 0.5 percent annual percentage yield (APY) would see $15 in growth 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 0.06 percent APY, you’d earn less than $2 after a year.
In five years that starts adding up — or not. Assuming the variable APYs stayed the same, you’d earn about $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 transaction accounts. If you need the ability to write a limited number of checks from savings, look for a money market account that offers check-writing privileges, in addition to a competitive APY.
2. Contribute to an IRA
If you’ve already filed your return, it’s too late to contribute to an individual retirement account for the 2021 tax year, unless you want to file an amended return. But you can take your refund and put it into a traditional IRA for the current tax year, plus what’s in the account can compound tax-free until you withdraw it, and the contribution may reduce your 2022 taxable income.
(If you haven’t yet filed a return, the deadline for contributing to an IRA for the 2021 tax year is April 18.)
If you’re eligible to contribute to an IRA, be aware of contribution limits: $6,000 for 2021 and 2022 for most filers; $7,000 for those 50 and older. 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? Check out Bankrate’s broker reviews.
3. Pay off debt
The average APR on variable-rate credit cards is 16.28 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 $5,525, according to Experian data from November 2021. If you paid only $100 a month toward the $5,525 balance it would take 94 months to pay off and cost an additional $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 at Landau Advisory in White Plains, New York. “So that’s usually the first thing I’ll suggest with a refund.”
MainStreet Financial’s Flannigan says there are two ways to approach paying off debt:
- Avalanche method: Focus on paying off the debt with the highest interest rate. Once that is paid off, move on to the balance with the next-highest rate. This method saves the most money.
- 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,” says financial planner Landau. “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.
To get the highest APY, banks used to offer tiered balances to encourage customers to put all their money in a single institution. 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.
With interest rates expected to rise, it 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.
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. It can be split 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, she 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,” Flannigan says. Or you can think of your tax refund like it’s forced savings.