February 20, 2020 · Budget, Investment, Taxes
Originally published February 20, 2019. Updated on February 20, 2020 with current contribution limits and other edits.
In the early part of the year, many of us are waiting for a tax refund check from the IRS, a commission payout or a bonus from our jobs for 2019. In terms of a refund, it is money that we earned in 2019, but the U.S. government held on to some of it as withholding taxes—a small amount deducted from each paycheck throughout the year.
An expected refund, commission or bonus can inspire exciting plans for spending our big check. Splurging on something self-indulgent and probably unessential, such as a luxury vacation, a car, or furniture, may seem justified. It’s natural to want to reward ourselves with a tax refund or bonus, which we may think of as an unexpected windfall, or “found money.” But remember: tax refunds are your money to begin with and you worked hard to earn your bonus. Both deserve the same responsible management as your other hard-earned income.
A Bankrate Money Pulse survey found that a record high of 29 percent of people will use tax refunds on necessities. That's great news, because the smartest thing you can do with any extra income is use it for necessities, including increasing your savings and decreasing your debt. That's why we’re offering a few recommendations to the question, “What should I do with my 2019 tax refund, commission or bonus money?”
Add More to Your Savings or Money Market Accounts—or Invest in a CD
It's always a good idea to add to your savings. For many people, they start building their financial resources with a basic savings account. Saving accounts earn interest and can be linked to include direct deposit of a paycheck or to a checking account.
If you want to have a flexible account that can earn a higher rate of interest for your savings, look at a Money Market Account. These accounts don't lock you into a fixed interest rate or long-term commitment. Often with these accounts, if you maintain a certain balance, you will earn dividends at a higher rate than a savings account.
A Certificate of Deposit (CD) is another way for you to watch your money grow at a higher interest rate than a savings account. It is like a savings account in that it helps you grow your money, but CDs are a time deposit. When you buy a CD, the money is invested for a fixed amount of time (fixed-term) and can be used once the certificate of deposit has matured – when the fixed-term is complete. CDs can be typically be invested for terms of 6, 12, 24, 36 or 60 months.
Put Money in an IRA or Other Retirement Savings Account
The additional funds you receive now can make a big difference in the future. If you use them to make an extra contribution to your Roth Retirement Account or a traditional Individual Retirement Account (IRA), they could significantly increase by the time you retire. If you don't already have an IRA, use your refund/commission/bonus to jump-start one. In 2020, the annual contribution limit for IRAs is $6,000 ($7,000 if you are 50 or older).
Max Out Your Health Savings Account
A Health Savings Account (HSA) allows you to save money for expected healthcare expenses, and it also offers tax advantages. In 2019, you and your employer could have contributed a combined total of $3,500 for an individual ($3,550 in 2020), or $7,000 for a family ($7,100 in 2020). People 55 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 qualified medical expenses is tax-free and, like a 401(k) retirement account, the HSA is yours to keep.
Build a Short-Term Emergency Fund
Finance professionals typically recommend saving the equivalent of three to six months’ worth of living expenses in a separate emergency fund to offset an unexpected job loss, medical emergency or other financial setback. That's why using your tax refund, commission or bonus payout to start or fully build up your savings is something you will be thankful for when you need it.
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.
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. Even paying down part of your credit debt will help save money.
And—Maybe—Do a Little Something for Yourself
If you eliminate high-interest debt, and fully fund your savings and emergency accounts, you may want to indulge just a bit in a smaller, more personal reward to thank yourself for your disciplined money management. Consider treating yourself—to a nice meal at a restaurant, some new clothes, a movie or concert, or something else that you would enjoy.
These tips are sound advice for using your additional money 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 carefully whether you should adjust your withholdings for next year, to prevent any refund at all. In other words, decide to have so little money withheld from your paycheck that you are sure to not receive a refund in 2021! 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.