It’s the time of year when many of us are awaiting a tax refund check from the IRS. It is money that we earned in 2015, allowing Uncle Sam to hang on to some of it in the form of withholding taxes – a little at a time deducted from each paycheck throughout the year.
The expected refund can inspire big plans for spending our big check. Splurging on something self-indulgent and frivolous, like a fancy vacation or even an automobile, may seem justified. After all, tax refunds can feel an awful lot like a windfall, or “found money.” But remember: this was your money to begin with, and it deserves the same careful management as your other hard-earned income.
A recent study found more Americans this year than last are considering saving their tax refund. That’s great news, because the smartest thing you can do with any extra income is use it to increase your savings, and decrease your debt. That’s why we offer these answers to the question, “What should you do with your 2016 tax refund?”
Pay Off High-Interest Debt, Such as Credit Card Bills
One of the best ways to spend your tax refund is to eliminate credit card balances and other types of high-interest debt. Reducing high-cost debt not only relieves the stress of making monthly payments. It also enables you to save hundreds, or even thousands, of dollars over time.
Put Money in an Ira or Other Retirement Savings Account
The refund you receive now can make a big difference in the future. If you use it to make an extra contribution to your Roth or traditional IRA, it could triple or quadruple by the time you retire. The IRS even offers a Direct Deposit option that allows you to have some, or all, of your refund sent directly to your IRA.
If you don’t already have an IRA, use your refund to start one. In 2016, the annual contribution limit for IRAs is $5,500 ($6,500 if you are 50 or older).
Max Out Your Health Savings Account
A Health Savings Account (HSA) allows you to prefund healthcare expenses and it also offers tax advantages. In 2016, you and your employer can contribute a combined total of $3,350 for an individual, or $6,750 for a family. People 65 and older can put in an additional $1,000. Money saved in an HSA reduces your taxable income, which can add up to significant savings.
Money taken out of your HSA for medical expenses is tax-free and, like a 401(k) retirement account, the HSA is yours to keep. You can invest it, and it grows tax-free.
Build an Emergency Fund
Finance professionals typically recommend saving the equivalent of three to six months’ worth of living expenses to offset an unexpected job loss or other financial setback. Unfortunately, many Americans fail to maintain an adequate emergency fund. Use your tax refund to start or fully fund yours.
The IRS also provides a free Direct Deposit option for savings accounts, allowing you to deposit your refund in up to three accounts in any U.S. financial institution. You can even direct your refund money toward the purchase of up to $5,000 in U.S. savings bonds.
These tips are sound advice for using your refund responsibly, but they are not your only options - especially if you have fallen into the habit of using withholding taxes as a sort of forced savings plan. One more piece of advice is to consider whether you should adjust your withholdings for next year, to prevent any refund at all. In other words, opt to have so little money withheld from your paycheck that you are sure to not receive a refund in 2017!
While a tax refund may sound like a windfall, it really means you overpaid on your taxes to begin with. If you can manage it, you might be better off to give up the year-end refund and keep the extra cash in each paycheck to save or use wisely throughout the year, rather than giving an “interest-free loan” to Uncle Sam.
And who knows? If you eliminate high-interest debt, and fully fund your savings and emergency accounts, you may also be able to splurge on (a little) something self-indulgent and frivolous.