Nobody likes to pay taxes, but everyone loves to get a tax refund — and about three in four Americans do, according to U.S. News & World Report. It’s such a great feeling when that refund check arrives in the mail, it can be hard to resist spending it on some indulgence.
Though the temptation might be strong, spending your tax refund on something stupid can amount to a missed opportunity to put it to better use elsewhere. But how do you best determine what to use it for? With your paycheck, there’s the idea of “paying yourself first” — assessing your financial needs and allotting portions of your paycheck for every need, with your savings account at the top. Your tax refund can play the exact same role — it’s just a matter of deciding where those dollars will make the most difference — whether you’ve received just $100 from Uncle Sam or 2013’s average refund of $2,755.
How to Spend Your Tax Refund: Prioritize
First and foremost, set a goal and action plan for your tax refund; if you let it absorb into your checking account, you’ll end up spending it on a number of minor expenses — from shopping to coffee — that don’t really matter. Pretty soon, you’ll have no proof that you ever received a check of several hundred or thousand dollars from the government.
Instead, you can use your refund to address problem areas or opportunities in your financial life. Here, in order of most to least importance, is where you should put your money.
1. Pay down your debts
Even the smallest tax refund can help pay a portion of outstanding debt, like a mortgage, car payment, credit card balance or student loan, giving your principal power over high interest.
“Using your refund to pay off a balance with an 18% interest rate is like earning 18% on your investments — an incredibly valuable use of the money,” writes Kimberly Lankford of Kiplinger. If debt is your biggest financial worry, you should consider devoting your entire refund toward paying it off, since a four-digit refund can help make a lot of progress in several of the above examples.
2. Pad your emergency fund
Experts say that everyone should have three to six months of money saved up to cover emergency expenses — but that’s not the case for most Americans. In fact, last year GOBankingRates found that 73 percent of Americans have less than $1,000 saved.
Without that buffer, you’re vulnerable to all sorts of unexpected occurrences — unemployment, a medical emergency, a hefty car expense. Start by building up a $1,000 cushion — deposit your entire refund into a savings or sub-savings account for emergencies.
3. Make tax-free contributions
If you’ve decided to save — and, to dedicate your tax refund toward it — aim to do it tax-free. Go beyond the rainy day fund and look into investing the money in a tax-deferred Roth IRA or 401(k) — or, if you’ve already got an Individual Retirement Account, sock away some more. Even $100 helps. Many tax refund recipients mistake their new gains as “free money,” but forget that it’s money they’ve already earned. Putting it toward your retirement means you will be spending it on yourself — eventually.
4. Start investing
Don’t stop your savings there. Your tax refund can also act as a foundation for other investments; according to Investopedia, “you might consider throwing it into a shorter term investment portfolio. Investing doesn’t have to be exclusively for retirement — it is also a way to see appreciation on capital that can be used to put a down payment on a house, buy a car, pay for college, or for any number of purposes.”
Don’t forget that a three- to four-figure tax refund is more than enough minimum opening deposit for many CD, money market and high-yield savings accounts.
5. Tackle some self-improvement
One way to spend your tax refund selfishly without wasting the money is to invest it in yourself — this could mean anything from taking a class at your local community college to getting certified for a skill to put on your resume. The payoff is that you’ll get to experience something that enriches your life and that might help you advance your career down the line.
6. Consider giving to charity
Your tax refund might be the only chance you get to include philanthropy in your budget. Not only is it personally fulfilling to give money to others in need, acting selflessly is proven to make you happier and physically healthier, too. If philanthropic giving has been a desire of yours for a while, but you’re undecided on what cause or organization to donate to, set your refund money aside in a separate savings account until you’ve decided how you’d like to divide the funds.
7. Allow some self-spending
All of this doesn’t mean it’s wrong to spend the money on yourself. If you’ve managed to meet all of the above financial needs with money left to spare, you deserve to treat yourself to something you’ve always wanted; think of it as a present, from you to you, for working hard all year long. What’s more, splurging a little has been proven to actually help you save money.
Make Use of these Tax Refund Resources
Keep in mind that if you’re receiving too big a tax refund, you might be withholding too much on your W-4 — and the experts are divided as to whether that’s smart.
The good news is that you can alter your income withholding at any time by filling out a new W-4 form for your employer. You can also estimate what kind of a refund (if any) you’re likely to receive for 2015 by using a W-4 salary calculator; take a copy of your 2014 tax return, a recent pay stub and play with the numbers to gauge how much you’re comfortable withholding.
Examining these financial steps might not give as much instant gratification as spending your tax refund in one fell swoop, but the smarts, security and savings that one tax refund can offer are worth every penny you’ve worked for.