What Should You Do With Your Tax Refund?
April 17, 2014If you’re like the average American, you’re getting a tax refund of about $3k this year. So what should you do with that nice windfall? Here are some things to consider before blowing it all on a random shopping spree.
Do you have at least 3-6 months’ worth of necessary expenses in savings? Your top priority should be to have an emergency fund of at least $1k but ideally enough to pay your necessary expenses for 3-6 months if you’re in between jobs. Otherwise, you could find yourself struggling to pay the rent or mortgage if a financial emergency strikes. (Make that when a financial emergency strikes.) One option is to contribute to a Roth IRA since you can withdraw the contributions at any time and for any reason without a penalty but as long as you’ve had the account open for at least 5 years, anything you don’t withdraw grows to be tax-free after age 59 ½. Just be sure to keep the Roth IRA somewhere safe like a savings account or money market fund if it’s part of your emergency savings.
Are you getting the full match in your employer’s retirement plan? While you can’t contribute the refund directly to your employer’s retirement plan, you can temporarily increase your contributions and use the refund to cover the shortfall in your paycheck. You may even discover you don’t need that extra income after all.
Do you have any high-interest debt? By “high-interest,” I mean more than the 5-7% you can expect to earn by investing the money, depending on how aggressive you are with your investments. If you can save more in interest by paying down debt, you should make that your next priority. After all, paying down a credit card balance with at 13% interest is like earning a guaranteed tax-free 13% return on that money. That’s pretty hard to beat.
Are you eligible for an HSA? If you have a high-deductible heath care plan, you may qualify to contribute to a health savings account. The nice thing about these accounts if that the money goes in pre-tax and can be used tax-free for qualified health care expenses. Unlike an FSA, the HSA money can be rolled over and even invested to be used for future expenses.
Have you maxed out your retirement accounts? You can use the tactic described above to contribute more to your employer’s retirement plan or you can contribute directly to an IRA. Either way, your future retired self will thank you. I’ve never heard someone complain about having too much money in retirement.
Do you have a minor child? You can put money in a 529 plan or Coverdell Education Savings account to have it grow tax-free for qualified education expenses. Just make sure your other needs are taken care of first as they don’t award financial aid for retirement.
Do you have all of those bases covered? Congratulations! Go take a vacation. Research shows that it’ll make you much happier than that spending spree.