Whether you've already filed your income tax or are about to, you may be looking forward to a nice big refund check from Uncle Sam. In fact, the average tax refund last year was about $2,700 which is more than a month's worth of income for 2 out of 3 taxpayers. Before you start thinking about ways to spend it, you may want to consider using that refund to enhance your financial life going forward. Here are some options in a general order of priority:
1) Get caught up on old bills. For many of the people we talk to on our financial helpline, a tax refund can be a lifeline in getting caught up with overdue mortgage payments and other bills. This can prevent you from losing your home or car, save you money in interest and penalties, and stop future damage to your credit report. However, you may want to think twice about paying that debt if you're planning to file for bankruptcy or the debt is old enough to be off your credit report and past your state's statute of limitations.
2) Put it in savings for emergencies. We've all heard that we should have at least 3-6 months worth of necessary expenses in an emergency fund, but according to our upcoming research report, nearly half (49%) of employees lack this vital piece of their personal safety net. That means they could be vulnerable to losing their home or car (or simply struggle to make ends meet) if they should lose their job. If you're in that category, you might want to put your refund somewhere safe and accessible for emergencies like a savings account or money market fund.
3) Pay down high-interest debt. The average household with debt in America has over $15,000 in debt, and the average APR is just under 15%. Putting $2,700 towards that debt could shave over 8 years off the payoff date and save $17k in interest. Doing it every year would pay off the debt over 14 years earlier and save almost $24k in interest. You can use our DebtBlaster calculator to see how much you can save.
4) Contribute to a Roth IRA. A Roth IRA allows you to put money away that will grow to be tax free after age 59 1/2 (as long as you've had the account open for at least 5 years). For example, a one-time $2,700 contribution that earns 7% on average per year will grow to be worth over $10k tax free in 20 years. Contributing every year would grow the account to over $118k tax free. In the meantime, your money isn't tied up since you can withdraw the sum of your contributions without tax or penalty (however, earnings may be subject to taxes and penalties if withdrawn before age 59 1/2). Earnings can also be used penalty free for education expenses or a first-time home purchase. Since it has no effect on your current tax liability, if you are eligible you can make a contribution of up to $5k—$6k if you turned 50 or older—to a Roth IRA for last year, even if you've already filed your tax return. You have until April 15th to make a contribution for last year.
5) Purchase U.S. Savings Bonds. If you've maxed out your retirement accounts, U.S. Savings Bonds offer you another vehicle for tax-deferred growth (plus, they are tax free at the state and local level). Series I Savings Bonds are currently yielding 1.76% and the interest rate is adjusted every six months for inflation. Series EE Savings Bonds are currently yielding only 0.2%, but because they double in value after 20 years, you'll earn about 3.5% if you hold them that long. Those rates may not sound too exciting until you compare them to 5-year CDs, which are averaging less than 1%, or 20-year Treasury bonds that are yielding about 2.8%. Unlike 20-year Treasury bonds, you don't have to worry about savings bonds losing value if interest rates go up, and they may be tax free if used for education expenses. On the other hand, you can't cash them in for the first 12 months, so they're not suitable for emergency savings (at least for the first year). You also lose the last 3 months of interest if you redeem them within the first 5 years of issue, but the series I savings bond would still be ahead of the average 5-year CD after just 12 months even with the penalty. You're normally limited to purchasing $10k per year on treasurydirect.gov, but you can purchase an additional $5k in paper I bonds each year with IRS refunds using IRS Form 8888.
6) Contribute to an education savings account. After your retirement plan is on track, you can save for your children's education in a 529 or Coverdell education savings account and have the money grow tax free for education expenses. If you invest in your own state's 529 plan, you may be eligible for a state income tax deduction. Contributions made by April 15th may be eligible for a deduction on your 2012 state tax return. Just be aware that the earnings may be subject to taxes and a 10% penalty if used for non-qualified expenses.
7) Go on vacation. If your financial needs are taken care of, go ahead and enjoy yourself, but consider splurging that refund on an experience like a vacation. Research shows that you buy more happiness that way than purchasing a luxury item that you really don't need.
For many Americans, the tax system can be their only way of saving for these various goals. The problem is that it isn't exactly the most efficient way of saving since you earn no interest on your money and don't have access to it until after you file your taxes. If you're receiving a large refund every year, you may want to adjust your W-4 tax withholding and save for these goals throughout the year instead. But don't go too far the other way or you might need to read this article next year instead.
Erik Carter, JD, CFP® is a resident financial planner at Financial Finesse, the leading provider of unbiased financial education for employers nationwide, delivered by on-staff CERTIFIED FINANCIAL PLANNER™ professionals. For additional financial tips and insights, follow Financial Finesse on Twitter and become a fan on Facebook.
