The Internal Revenue Service (IRS) tax season recently began and is set to run through the filing deadline of April 15, 2021. If you’re due a refund after filing your tax return, you can expect to receive it within 42 days. This means that by the beginning of June, you could receive an influx of cash in your bank account.
But what should you do with this extra money? The answer depends on your financial situation. Statistics show that 50% of those planning to receive a refund will put it into savings, 34% will pay down debt, and 22% will put it toward everyday expenses. A combined 40% of people, however, said they would put the refund toward a vacation, home improvement project, major purchase, or “splurge” purchase.
If you’re expecting money back from the IRS or your state government this year, you should look into how to use your tax refund wisely. This cash boost could help improve your financial situation rather quickly if you’re strategic about what you do with it. In this article, we offer seven tips for how to use your tax refund wisely in 2021 so that you can achieve your financial goals.
1. Build Your Emergency Fund or Rainy Day Fund
Bankrate recently found that only 41% of Americans would be able to cover a $1,000 emergency with their savings account. The need for an emergency fund has perhaps become more evident in the wake of the recent pandemic, as millions of workers were unexpectedly furloughed without pay. Emergency funds help long-term unexpected circumstances, like job loss or medical emergencies.
It’s recommended to have at least three to seven months’ worth of expenses stashed in a savings account. Putting this money away can give you peace of mind knowing that you can maintain your basic way of life should an emergency arise. Tax refund money is an excellent way to get a head start on your emergency fund.
Once you’ve built up your emergency fund, you can then turn to financing your rainy day fund. Although the terms are often used interchangeably, there is a difference between emergency funds and rainy day funds. Rainy day funds are meant to cover unexpected, one-time expenses — think of things like new tires on your car or a new roof on your home.
Experts recommend having $1,000 stashed away in your rainy day fund. Using the extra cash from your refund check could put you well on the way toward meeting this goal.
2. Pay Off High-interest Debt
Another strategic way to use your tax refund is to pay off your high-interest credit card debt, such as those from credit cards. Credit card debt is problematic for your personal finances for two reasons. First, interest rates are usually very high, often upward of 20%. Second, credit card interest compounds, which means you’re charged interest on top of interest. These two things combined could cost you tens of thousands of dollars in the long run.
Putting your refund toward your debts with the highest interest should significantly reduce your monthly payments, making it easier to pay down debt in the coming year. Reducing your total debt will also help your credit score as well.
Although credit card debt often has the highest interest rates, other forms of debt that may have high rates include:
- Payday loans.
- Debt consolidation loans.
- Personal loans.
- Car title loans.
- Student loans.
To pay down high-interest debt, look into the debt snowball and debt avalanche methods. Your total debt and the amount of your return will determine which strategy is best. If you’re still unsure, you can also consider a credit card payoff app like Tally. Tally manages your money by automating monthly payments and paying down debt in the most strategic way possible to help you save on interest.
3. Boost Your Retirement Accounts
You may have access to a 401(k) through your employer, but that may not be enough for retirement. There are a few things you can do to build your retirement accounts.
If you’re going to receive a sizable refund, you may want to adjust your 401(k) contributions through your employer. For instance, let’s say that you’re expecting a refund of $3,600 this tax year. You plan to put $1,200 toward debt, $1,200 toward a savings plan, and the remaining $1,200 toward retirement. You can ask your employer to increase your monthly 401(k) contributions by $100 a month for the next year.
Another option is to fund an alternative retirement account, like a traditional or Roth IRA. An IRA is similar to a 401(k), except that you manage it instead of your employer. Roth IRAs do have contribution limits based on filing status and adjusted gross income.
Another option that might be worth considering is a traditional IRA, which uses pretax income to fund the account. In other words, the contributions you make to a traditional IRA are tax deductions. Doing so lowers your taxable income, which could actually increase your income tax refund. However, all withdrawals are taxed upon removal. So if you think you’re going to be in a higher tax bracket down the road, then the Roth is the better option because investment in this type of IRA is made with after-tax dollars.
4. Hit Savings Goals
Though we’ve stressed the need for emergency and rainy day savings, you may have other financial goals that you want to accomplish. You can use your state or federal tax refund to save for a major event, like a new car or a down payment for a new home. If you already own a home, putting your refund toward something that will increase your home’s value, like a new kitchen, might take priority.
You should only consider these options if you have your basic savings accounts in place. It’s probably more important for you to have an emergency fund in place than it is for you to upgrade a bathroom in your home. It’s also important to have an emergency fund if you’re looking to buy a new home. Lenders will need to see that you have cash on hand.
5. Donate to Charity
Donating your tax refund to charity may seem like you’re giving the money away. However, doing so could have an impact on future taxes. If you itemize your tax return, you can deduct your charitable donations. Doing so will reduce your taxable income, thus lowering how much you owe in taxes.
Let’s say that at the end of 2020 you found out that you would be receiving a sizable raise from your employer. With this extra income comes additional taxes. You could donate your tax refund and essentially offset your raise so that you’re not being taxed on the additional income. This could give you even more financial flexibility down the road.
6. Invest in Future Education
If you have children who will one day go to college, you can consider putting your tax refund toward their future education. There are education savings accounts and 529 plans available. These not only allow you to save for your children’s education but also to receive tax benefits. The contributions to these accounts are tax-free, much like a Roth IRA.
7. Plan for Your Future
It may not be at the front of your mind, but you may want to consider using your tax refund to plan for your future. You should have an estate plan and will in place. Should you pass away, you will leave behind everything you own, including assets and debt. This process quickly becomes messy without an estate plan in place. You can use your tax refund to hire an attorney to draft your plan.
Similarly, an investment in life insurance may be a good way to spend a tax refund. Types of policies vary, and the payout that occurs upon your death will depend on the type of policy you purchase. Life insurance is particularly useful if you’re still working and have children or other people who depend on your support. Your tax refund could allow you to upgrade your plan or open a policy, protecting your family in the future.
How to Use Your Tax Refund Wisely
By the beginning of June, millions of Americans will have received their federal tax refunds. Before you receive yours, taking time to figure out how to use your tax refund wisely is a good idea. How you decide to use your refund depends on your financial situation and goals.
However, considering the following seven options is an excellent place to start:
- Build your emergency fund or rainy day fund.
- Pay off high-interest debt.
- Boost your retirement accounts.
- Hit savings goals.
- Donate to charity.
- Invest in future education.
- Plan for your future.
In 2022, the Biden tax plan could result in middle-income Americans receiving even more money on their tax returns. If you’re able to pay down debt this year using tools like Tally, you’ll give yourself more flexibility next year with how to use your refund.
Learn how Tally can help you manage your credit card debt.