As tax season rolls around each year, it’s usually either a time you dread or a reason to celebrate. If you’re one of the fortunate ones who are receiving a tax refund, it can be tough to decide how to spend your money. But have you considered all the useful reasons to save it? Read on for some helpful tips on what to do with your tax refund.
What is a tax refund?
A tax refund may feel like you’re getting “free” money, but it’s actually money that the Internal Revenue Service (IRS) has held for you. The typical scenario goes like this: when you receive a paycheck, your employer withholds a certain amount of money in taxes to send to the IRS. At the end of the year, you look at the money that was sent to the IRS and compare it to the amount you owed the IRS. After deductions, your tax refund is the overpayment of your taxes that the government owes you. In essence, you’re essentially getting your own money back instead of the “bonus” it feels like you’re receiving. If you’re wondering how much you’ll get, several sites offer free tax calculators to help you estimate your potential IRS refund. Just remember, it’s an estimate, and not an actual tax preparation software or a tool. You can also consult an accountant or tax advisor if you want more accurate figures.
When do tax returns come?
Your tax return depends on when you file your taxes. By law, employers must send you any employer and payroll-related tax forms by January 31st of every year. If you haven’t received these documents by now, contact your employer immediately. You can file your taxes as soon as you have all of your tax documents. You can file your taxes through the mail, or you can file your tax return online. You can even use tax preparation software to help make filing your return a little easier. It generally takes up to three weeks to receive your tax refund after you’ve filed your taxes. Your refund may arrive sooner if you opt for an IRS refund via direct deposit instead of a paper check by mail.
Deciding what to do with your tax refund
Depending on the amount of your refund, you have an important decision to make. For example, you could spend your IRS refund check on a well-deserved vacation. Maybe donate some of it to your favorite charity. You could even pay down your debt or tuck some of that money away for a time during the year when you might need a little extra cash. So take a few days — or longer if needed — to make an informed, confident decision you are comfortable with.
Reasons to invest your tax refund
Who could blame you for looking at your refund and the idea of a luxurious or adventurous vacation comes to mind? Or maybe going on a shopping spree for a big-ticket item? Yet, if you invest your tax refund, you’ll reap several benefits both right now and down the road. Here are five great reasons to invest your refund:
1. Prepare for the unexpected.
As tempting as it is to make huge impulse purchases, nothing feels better than knowing you have set aside a chunk of money for an emergency. Yet only 4 in 10 Americans have the means for “emergency savings” which has long been considered a basic wealth-building goal.
Life usually comes with many twists and turns, like a major car repair, medical bills or even the sudden loss of a job — which can all put a sudden strain on your monthly budget. For example, would you have the equivalent of six to 12 months of your salary saved up to cover expenses if you were to lose your job? Not many people do, but there’s a simple way to start. By consistently saving a little each month, your emergency fund will build over time. At the very least, consider putting money aside to help cover unexpected expenses like a leaky roof or a trip to the ER.
2. Discover the concept of compounding investment earnings.
No matter what savings vehicle you choose to invest your money, whether it’s in a bank account, CDs, stocks, bonds, retirement savings or a combination of places, the key to saving is to make your money work for you. It does this through the power of compounding. Compounding investment earnings is what can make even small investments become larger given enough time. Simply stated, compound interest means that you earn interest on the original amount you’ve saved, and then you continue to earn interest on the interest. When you choose to save or invest your tax refund, you have the potential to make money on the interest in your account that accrues over time. It’s also a smart move to consult with a qualified financial planner beforehand who can help you invest wisely and track your progress.
3. Invest your tax refund to meet short- and long-term goals.
Investing your refund can help you reach both your short and long-term goals. For example, saving your tax refund enables you to save up for that new car you’ve always wanted or go on a trip you’ve been dreaming about. While this may feel like you’re simply splurging on a big ticket purchase, you’re actually working toward a goal and reducing the need to take out a huge loan or put it on a credit card, which just creates more debt. Or you could work toward a long-term goal, such as buying a home. Saving your tax refund each year can help you increase the down payment you make on a home, which could mean a smaller monthly payment. To help plan for how much you might receive, a tax refund estimator can help you determine how much you should expect from your IRS refund.
4. Retire in style.
For many of us, retirement feels so far away. Yet saving for your retirement is one of the best ways to use your tax refund. Even if you’re in your 20s or 30s, putting away a consistent monthly amount in tax deferred investments like an employer-sponsored 401(k) savings plan now means the money you’ve invested will have the potential to earn compound interest over the years, all making a larger nest egg for retirement.
With more and more people living longer in retirement, you’ll probably need more savings than you’ve anticipated. Your tax refund can help give your retirement savings a boost if you haven’t started investing in a plan yet or want to increase the money you’ve set aside for your golden years. And it’s always a good idea to get a head start on planning for your future financial, medical and legal needs.
5. Enjoy peace of mind.
A sense of security is probably the number one reason to invest your refund instead of spending it. Knowing that you’ve taken the money you’ve earned and have set it aside, whether for emergency funds, buying a home or retirement, can give you the added confidence that comes from making a solid, wise financial decision, as well as the peace of mind that you or your family will be better protected in the future.
Different Ways to Save Your Refund
Once you’ve decided why you want to invest your tax refund, you’ll need some tools to help put your dreams into action. The following five investment vehicles are some of the most common ways people save their tax refunds:
Contribute to your IRA.
Putting money into an Individual Retirement Account, or IRA, is a great way to use your refund, especially if your employer doesn’t offer a retirement savings contributions vehicle. The goal is to save around 10 percent to 15 percent of your salary for retirement. Depositing all your tax refund into your IRA every year is a solid, consistent way to help you meet your long-term retirement goals.
Pay down a credit card - or two!
Many credit cards issuers charge users around 16% for unpaid monthly balances. If you don’t pay off your interest every month, you end up paying interest on your interest. Use your tax refund to start bringing those numbers down every month by using your refund to make a dent in your credit card balance.
Save for college as soon as possible.
Open up a 529 college savings plan to start saving for your kids’ college education. It’s a great way to save on a consistent basis, and these plans allow you to deduct the amount of money in your account from your tax return that you file to the state every year. College expenses keep growing every year; by putting some of your money towards a college plan, you can actually save money while saving for your kids’ future.
Consider additional protection with insurance.
Your insurance plans should include not just health, home or renter insurance. You should also consider legal insurance should you ever need an attorney for a situation like estate planning needs, fighting a traffic ticket or a dispute with a home contractor. You can also consider other types of insurance coverages that can help pay your bills if you are too sick or unable to work.
Saving your tax refund every year isn’t always necessary, but consider the positive side to the investment. You’ll probably end up spending the money at some point, but you should let the money work for you for as long as you can.
