January 06, 2021 · Budget, Investment, Retirement, Savings
In the early part of the year, some people may be waiting for a stimulus payment or tax refund check from the IRS, a commission payout, or a bonus from our jobs for 2020. In terms of a refund, it is money that we earned in 2020, 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 new money. Splurging on something self-indulgent and, maybe, unnecessary, might seem justified, as the COVID-19 pandemic of 2020 was stressful for many people, both financially and in other ways. It’s natural to want to reward ourselves using part or all of a tax refund or bonus, which we may think of as extra money that’s different from our regular pay. Keep in mind that tax refunds are money that you’ve already earned. Whether it’s your regular pay or a refund, commission, or bonus, you should be still be responsible with how you use that money.
A 2020 National Retail Federation® survey found that approximately 50 percent of those surveyed planned to use their tax refund to contribute to savings, while the next highest percentage, 34 percent, were going to use the refund to pay down debt. The third highest group of survey respondents, 24 percent, intended to use their refund for “every day expenses.” These survey results are 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 you do with your 2020 stimulus payment, tax refund, commission or bonus money?"
If your job was affected by the pandemic, it may be that the best thing you can do with any additional money is to stay current with your regular financial obligations, pay bills and pay down any additional debt you may have accumulated, such as credit card balance interest.
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.
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 IRA 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 2021, the annual contribution limit for IRAs is $6,000 ($7,000 if you are 50 or older).
A health savings account (HSA) allows you to save money for expected healthcare expenses, and it also offers tax advantages. In 2021, you and your employer can contribute a combined total of $3,600 for an individual, or $7,200 for a family. 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, similar to a 401(k) retirement account, the HSA is yours to keep.
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. As the 2020 pandemic unfortunately demonstrated, for many Americans it can be difficult to ever start, let alone maintain, an adequate short-term emergency fund. That's why using your stimulus payment,tax refund, commission or bonus payout to start or 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, including savings and checking accounts. You can even direct your refund money toward the purchase of up to $5,000 in U.S. savings bonds.
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. Another option for cutting your debt is to take out a car loan, personal loan, or home equity line of credit, and use the loan to pay off other debt that has a higher interest rate—and then you have more money available to pay off the new, lower-interest loan faster.
You may want to add this extra money to existing investments, or, if you don’t currently have investments, consider carefully if now is a good time to research if financial investing might be appropriate for you. Delta Community's CERTIFIED FINANCIAL PLANNER™ professionals are available to discuss what your investment options are, and they are committed to providing our members with thorough advice so they can make informed decisions. If you're interested in learning more about investing, check out our Financial Education Center to see a list of free financial education workshops; for details please visit the Events page on our website.
If you're in a strong financial position, consider if you might want to help others with that additional money you’ve received. Perhaps you can assist a family member or a friend in need, or support a charitable organization. If the organization is tax-exempt under section 501(c)(3) of the Internal Revenue Code then your contribution may be tax deductible—so you are helping others and helping yourself by lowering your 2021 taxes.
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, but not extravagantly—give yourself a nice takeout meal from a restaurant, some new clothes, rent a movie from a streaming service, buy music, a book, or videogame, or do something else that you would enjoy.
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 in 2021 that you are sure to not receive a refund in 2022. While a tax refund may sound like a windfall, it really means you had overpaid your taxes. Consider not using withholding taxes as a sort of forced—but effective—savings plan; if the money isn't available to you because it's held by the federal government then it is easy to save what you can't access and spend.
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, invest or use wisely throughout the year, rather than giving a loan to the U.S. government.