The average individual tax refund for 2020 was $2,827 — a hefty chunk of change. While it might be tempting to splurge on a vacation or a shopping spree, there may be better ways to use that refund. A tax refund, especially during tough economic times, can be a great way to help strengthen your personal finances, whether by paying off debt, boosting savings, or investing in your future.
What is a tax return?
A tax return is a form, or forms, filed with a tax authority that reports the total income an individual has earned throughout the previous calendar year, as well as any expenses, deductions, and tax credits the taxpayer is eligible to receive. A W-2 employee has their taxes deducted by their employer from their paycheck each pay period. These deductions include state and federal income tax, as well as Social Security and Medicare payments.
For many taxpayers, more earnings are deducted for federal and state taxes than is required. When a taxpayer calculates on their forms that they overpaid in taxes, they are eligible for a refund. If you receive a refund and are looking for ways to improve your personal finances, here are seven ways that could benefit your financial life.
1. Build an emergency fund
Don't have enough money saved for a rainy day? Building an emergency fund is one of the first things you should consider putting your tax refund toward as it can help you to weather tough financial times, pay for emergency expenses and get back on your feet. Ideally, you should have three to six months' worth of expenses saved up in case you have a disruption in your income, whether because you've been laid off from your job or are unable to work due to illness or injury.
2. Pay off high-interest debt
If you have high-interest debt, such as a credit card balance or a personal loan, consider using your tax refund to help pay it off. High-interest debt can inhibit your ability to save money or build wealth and it accumulates additional interest over time. The sooner you eliminate debt the sooner you can start saving more money and improving your financial circumstances.
3. Start several savings buckets
If you have savings goals for major purchases, such as a wedding, vacation, new car or new home, starting several savings buckets can help you to visualize your goals and increase your savings. You can spread your tax refund out among each of these accounts and commit to increasing your savings an additional amount each month.
4. Contribute to your retirement fund
It's never a bad idea to put a tax refund windfall towards your retirement savings. Any money that you're able to put away early in your career can dramatically increase by the time you reach retirement age. As a bonus, many types of retirement accounts are tax-advantaged, which means your money can work even harder. Whether you have a retirement account such as a 401(k) that you contribute through work, or a traditional or Roth IRA that you contribute to on your own, these accounts are a great place to stash a tax refund.
5. Invest in the stock market
If you've already maxed out your retirement contributions for the year, you might want to consider investing your tax refund in the stock market. You should open up an account with a brokerage to begin investing. If you have young children, consider opening up a 529 plan to save for college instead. You can also consider investing in peer-to-peer lending, real estate, or even cryptocurrency. While no investment is risk-free, these options can be a great way to grow your money.
6. Contribute to a health savings account
A health savings account, or HSA, is a tax-advantaged account that you can set up specifically to fund healthcare costs. You can use the money you save in an HSA to pay for qualified healthcare expenses. Once you turn 65, you can withdraw the funds to be used for any purpose, whether healthcare-related or not, making HSAs another attractive option when it comes to saving for retirement.
7. Invest in yourself
If you're already in good financial shape, the best use of a tax refund may be to invest in yourself. Giving yourself the necessary conditions to flourish personally and professionally can be incredibly valuable both in financial terms and in your overall wellbeing.
Consider using your tax refund to pay for an advanced certification that can help you to level up at your job, or take a course in a subject that interests you, learn something new, or improve your skills. You could further develop a hobby that you've been pursuing. Or you may like to spring for a weekly fitness class or invest in a burgeoning side hustle.
[This article was originally published on Simple Dollar in June, 2020. It was updated in November, 2021.]