Filing taxes is not an event most look forward to each year, however, with nearly 75% of filers receiving a refund, tax season can result in a financial windfall. While anxiously awaiting your refund, consider where you will spend the check once it arrives.
According to a recent USA Today article, 41% of Americans use all or part of the tax refund to build their savings or emergency fund. Improving your savings balance can reduce reliance on high-interest debt to cover unanticipated costs. When you lack adequate savings, financial surprises can turn into a financial hardship. Nearly half of surveyed workers do not have adequate savings or emergency funds, which can put your home or car at risk when unforeseen expenses occur.
Financial advisors recommend having three to six months’ worth of expenses in an emergency fund to pay for expenses should you experience an interruption in income. The emergency account should be separate from general savings, which can pay for irregular costs such as vacations, holiday spending, car or home maintenance, or quarterly insurance premiums.
Without an adequate emergency fund, you are financially vulnerable in a medical emergency, job loss, or other income disruption.
To make saving your refund easier, the IRS allows a direct deposit into a maximum of three accounts. Applying funds directly into a savings account or emergency fund reduces the temptation to spend the money on other things.
Whether you are savings for a specific future purchase such as a car or a home, or general savings, it will build financial reserves and increase financial stability.
Invest in Yourself
Furthering education can lead to higher paying jobs and increased job security. Investing a refund in additional job training can also lead to education tax credits the following tax year.
Saving for retirement takes on a new sense of urgency as more workers must provide the majority of funds used in retirement. The rapid decline in pensions and more frequent job changes impact your ability to build an investment portfolio large enough to fund 20 plus years of retirement.
Funneling your tax refund into a retirement account can supercharge savings, leading to faster account growth. Long-term investments perform best when they have decades to grow. For example, if you contributed $2,500, earning 7% annually, it will grow to over $10,000 in 20 years. Increasing retirement contributions above your current monthly allotment can add thousands of dollars to retirement account balances over time.
Improving Insurance Coverage
Purchasing insurance protects your finances in the event of unexpected costs. You should insure against life events you cannot pay for on your own. Begin with an annual review of current coverages, which could uncover areas you want to improve coverage. For example, you might decide to increase the amount of life insurance you carry, lower your deductible on a home or auto policy, or add disability coverage.
Invest in your child or grandchild’s future with a 529 or an education savings account. Dedicated accounts designed to pay for the cost of furthering education can offer significant tax benefits. Some accounts accrue tax-free for future educational needs. Each account has different rules. Review your options and choose the one with the most advantageous benefits for your needs. With the growing cost of a college education and the rising burden of student loan debt, using a refund to increase savings earmarked for education can provide significant long-term benefits for dependents or heirs.
Maintain Your Residence
Your home can be a valuable asset offering tax-free growth, provided you maintain the house. Couples can sell a primary residence and keep up to $500,000 in gains, tax-free, provided you live in the home for two of the last five years. Spending money on home improvements can increase the resale value and raise your net worth.
Buying real estate is typically the largest purchase you will make, and regularly improving the home, protects the investment. You would not drive a vehicle without changing the oil or purchasing new tires. Homes also need regular servicing.
Popular ways to upgrade your home to improve its value can include refining curb appeal, increasing the home’s energy efficiency, or upgrading key rooms such as the kitchen or bathrooms. Improvements such as replacing an entry door with a steel replacement or adding fiberglass insulation to the attic can give you a return on your investment of 89% or higher.
Older homes benefit from upgrades, which will also reduce monthly power bills. For instance, replacing single-pane windows, a new HVAC system, or upgraded appliances, all lower energy bills while improving the value of your home.
Free Yourself Financially
Tax returns can be a financial lifeline if you are struggling to keep up with current payments. The windfall can catch up late bills or pay down high-interest debt reducing monthly costs. A refund can be a way to reset your finances.
Lowering debt levels and catching up late payments will improve your credit score, bring late accounts current, and reduce fees and penalties on delinquent accounts.
When tight finances become an everyday challenge, choosing the best strategy may not be obvious. Before deciding which accounts to pay down or pay off, consider your overall financial circumstances. Will paying off one debt allow you to make on-time payments on all other bills going forward? Will the refund, provide the solution to your cash flow problems or will you have more late payments in a few months? Exploring all options will help you determine the best strategy for debt reduction.
Making wise financial decisions with your tax refund can increase financial stability and create a stronger financial future.
Before relegating yourself to a large annual check in the form of a refund each year, look at why you are receiving the money. In most cases, a refund represents an overpayment to the IRS. You can give yourself an immediate raise by increasing the withholdings from your paycheck and decrease next year's refund.