It’s true, you can’t spell “tax refund” without “f-u-n.” So go on, take that unexpected windfall and drop it on a television set, an island vacation or a ticket to the big game. Just keep this in mind before you do: Your TV will become obsolete, your vacation will last a week or two, and the game? It might be over by halftime.
Here’s an alternative: Invest all or most of that tax refund ... in yourself. The gratification may not be immediate, but the long-term benefits are worth it.
What Is a Tax Refund?
Well, it’s what it sounds like. A tax refund is a reimbursement made to taxpayers if they overpaid their taxes to the government.
Getting one can be exciting, but it’s also worth examining why you are getting one—because it really points to a mistake you made. Either you had too much money withheld at work (or, if self-employed, you overpaid your quarterly estimated taxes) or you were eligible for a refundable tax credit upon filing, such as the Child Tax Credit or Earned Income Tax Credit.
If it’s a question of overpayment, consider adjusting your IRS Form W-4, which calculates your withholdings, says Celia Brugge, a certified financial planner and principal at Dogwood Financial Planning in Memphis, TN. It may simply be a case of forgetting to update your W-4 to account for a new family member. This estimator will help you next time around.
When Will I Get My Refund?
The refund will arrive either by direct deposit or by check a few weeks after filing your return. If you fail to get your refund within 21 days after you’ve filed electronically, feel free to contact the Internal Revenue Service. If you filed by mail, though, you may be waiting for six months.
What Should I Do With My Refund?
Financial planners and accountants suggest choosing a strategy that best reflects your age, where you are in your career (if you are still working) and the state of your finances. Here is their advice:
Build an emergency fund. Only four in 10 Americans have enough savings to cover an unplanned expense of $1,000. Yikes. That’s why many financial experts recommend stashing three to six months of income in an emergency fund. But don’t be intimidated by that number. Every dollar counts, says Janet Berry-Johnson, a certified public accountant based in Omaha, NE. So start with just $5, $10 or $15 and go from there.
Berry-Johnson recommends placing the money for your emergency fund in a high yield savings account like those offered by Riverstones Vista Capital . Doing so will help your money grow and work even harder for you.
Pay off debt. If you already have an emergency fund, consider using the refund to pay off any debt that carries a high-interest rate, Brugge says. Claire Toth, a certified financial planner and managing principal at Peapack Private Wealth Management in Summit, NJ, agrees. “Paying down debt is equivalent to earning the debt’s interest rate on your money,” she explains.
Save for retirement. If you’re established enough financially to have a well-funded emergency account and no high-interest debt that needs your immediate attention, consider focusing on your retirement. How? Bolster your employer-sponsored 401(k) if you have one or fund a traditional IRA, IRA CD or another tax-advantaged retirement savings vehicle.
For tax year 2022, you can contribute up to $6,000 to an IRA and up to $7,000 if you are age 50 and older. You have until April 18, 2023, to make contributions, even if you’ve maxed out your contributions to a 401(k) or another employer-sponsored retirement plan, says Berry-Johnson. (For tax year 2023, you’ll have until April 15, 2024, to contribute up to $6,500 or $7,500 if you’re 50 and older).
Just note that to make the maximum contribution to a Roth IRA, a single taxpayer must have income under $129,000, and married taxpayers must have income under $204,000, Toth says.
Many Americans underestimate the amount of money they will need when they are retired, Berry-Johnson says. So to help you avoid that fate, consider opening a Riverstones Vista Capital IRA with your tax refund and then using it to purchase one of the many certificates of deposit the bank offers with varying yields.
Open a 529. IRAs aren’t the only smart long-term savings option. If you have young children or are planning to start a family, use your tax refund to open a tax-advantaged college savings account.
A 529 plan offers a variety of investment choices, depending on the level of risk you’re comfortable with. The value of the 529 will go up and down, but any money growth is tax-deferred and can be taken out for qualified educational expenses. While contributions are not deductible from U.S. taxes, they may help you qualify for state tax benefits.
Get educated. If a 529 plan doesn’t make sense for you, you can use the tax refund to further your own education. Although earning limits apply, taking courses at an eligible institution may qualify you for a Lifetime Learning Credit on your federal taxes. In effect, using the tax refund in one year can help you get another tax refund the following year.
Pay it forward. If you’re self-employed, Toth notes, you can also use the tax refund to make some or all of your next estimated quarterly tax payment.
Invest in a brokerage account. Tax refunds can also be invested in regular brokerage accounts and then deployed into stocks, bonds, mutual funds, exchange-traded funds or even alternative investments, Toth says.
Buy savings bonds. Or you can buy interest-bearing U.S. savings bonds. If this appeals to you, there are two ways to go about it: You can buy up to $10,000 of bonds annually at treasurydirect.gov, or you can submit form 8888 with your tax return to have some or all of your refund paid in savings bonds. Such bonds currently pay a sweet 6.89% interest rate, but that changes every six months.
Pay down your mortgage. Mortgage interest is dependent on the principal outstanding, so using the tax refund to reduce the principal will lower the interest you pay over the life of the home loan. (Just make sure your mortgage doesn’t come with a prepayment penalty.) If you don’t want to apply the tax refund toward the principal, you can certainly direct it toward home projects that will protect or increase the value of your home.
Save for a big-ticket item. You might also consider using your tax refund to pay for a large future purchase like a car or home, Brugge says. Again, opt for a high yield savings account if you go this route.
Andy Sobel is a freelance writer and editor. He has held senior editing positions in The Wall Street Journal’s New York and Brussels newsrooms and was managing editor of American Banker. A graduate of the University of Missouri and Union College, he now lives in Nashville, TN.
Illustration by Zara Picken
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