When you receive your annual tax return, it is easy to think of this sum as bonus money and use it to splurge. However, it is important to remember that tax refunds simply cover the difference between what you paid in taxes and how much tax liability you have in a given year. How much you get back depends on your financial situation, which tax credits you qualify for and how much money was withheld from your paycheck each month (or how much you paid in quarterly taxes, if you’re self-employed). The average tax refund in 2021 was more than $2,800.

 

There are many ways to use your tax refund, and it is wise to view your refund as accumulated savings rather than extra cash to burn. Using your tax refund to help pay off your debt could be a great way to strengthen your credit and overall financial health.

Can you use your tax refund to pay off credit card debt?

According to a 2021 survey from CreditCards.com, 25 percent of Americans expecting tax returns last year planned to use it to pay down debt balances. Paying debt was the second most common response among survey respondents, after saving the refund money (28 percent).

 

Consider the fact that the average credit card comes with an APR over 16 percent. If you carry the average credit card debt for American adults, which was $5,897 in 2020 according to Experian, at that rate, and with a monthly payment of $177 (3 percent), you might spend 45 months paying it off and pay $1,952 in interest in the process.

 

That’s a lot of money to give 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 your 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, and very few downsides. 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.

 

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.

Balance transfer credit card

Consider transferring your debt to a balance transfer credit card that offers an introductory 0 percent interest period. You can use the balance transfer to stall interest accumulation and funnel the cash from your refund directly toward 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 the entire balance off in full by the time interest begins to accrue again.

Debt snowball method

If a balance transfer credit card 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 $5,897 on a credit card with an APR of 16 percent. If you forked over the average tax refund amount of $2,535 right away and kept making a monthly payment of $177, you could pay off your debt in 23 months instead of 45 months and pay just $540 in interest.

Boost your credit score

Because 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 left over, there are plenty of other smart ways to use your tax 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: 73 percent of respondents say the money they expect to receive is important to their financial well-being.

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 three to six 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 keep 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 2021.

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, clearly explain to your lender that 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.