So you were lucky enough to get a tax refund. Congratulations. But before you think of this as an end-of-year bonus or money you can fritter away, realize it is actually just the money you already earned for the most part. Sure some of the refund may be due to a tax credit or other tax break you got, but for the most part tax refunds are just returning the money you overpaid to the IRS by withholding too much in taxes. So like your other earnings and savings be smart about this windfall. Also as some background here is how your refund compares to others, based on a research report from the American Tax & Financial Center at TurboTax. Highlights include:
- An estimated $200 billion in federal tax refunds will be issued this tax year to American taxpayers, fueling the U.S. economy and marking one of the biggest paydays of the year for the average U.S. family.
- Approximately 40% of taxpayers live paycheck-to-paycheck and rely heavily on the refund payment (and hence the frustration with recent delays). The average refund last year was around $2,800 and equals more than a months’ worth of income for two-thirds of taxpayers or more than three months’ worth of groceries for a family of four. Over the recent tax year this is expected to be even higher given the $10,200 unemployment tax credit enacted under the ARPA stimulus bill.
- Where are tax refunds spent? The pie chart below shows this breakdown, with most of the refund going towards paying down debt or bills. The average tax refund could cut almost a third of the average credit card debt.
- Only 25% of tax payers will save at least some of their tax refund. Hopefully they invest some of this for longer term to get a further boost from compounding. But I do know of several people that used their refund money to open up a free Robinhood account and trade some of the more popular stocks and crypto.
- Unfortunately it looks like 16% went to splurges, which is fine but not a great use of the money.
- Approximately 84% of taxpayers that file on the earlier side (before Feb 15th) receive a refund, compared to just half of those filing in April. But the past year has been a bit more wild with delayed IRS refund processing given all the stimulus payments and new tax credits.
So how should you spend and invest your tax refund?
Here are my top 5 ways to make the most of your refund, many of which people are already doing based on the research report findings.
1. Pay off high interest debt, like that on credit cards and personal loans. This will deliver the biggest bang for your bucks over the long term.
2. Create or add it to an emergency fund that gives you three to six months of cushion if you or your family lose your jobs or run into a financial emergency. Put this money into a good high yield savings account
3. If the refund is substantial enough, invest it. Find a good low cost broker like Robinhood and open up a trading account with the refund check. Then do your research and make your money work and grow for you! The easiest and best longer term option is to pick a broad based S&P index fund from Vanguard or Fidelity.
4. If you own a home, use the refund to make an accelerated or larger home loan payment. Making just one extra monthly payment a year on a 30yr loan can reduce the loan term by up to 7 years saving you a lot in mortgage interest
5. Finally and by no means the least, give the refund to charity if you can truly do without it. Helping others is a grand gesture and if you can afford to do it.