As the tax filing season approaches, many people are looking forward to getting their tax return filed so they can get that long-awaited tax refund. That payment from the IRS comes with a big question: What should I do with my tax refund? Another equally important question: What shouldn't I do with my refund?
To get your refund you must first file your tax return
You can either file your return yourself by following the instructions on your federal and state forms, or you can pay a tax specialist, such as at H&R Block, to file on your behalf.
This is a particularly tricky time to file as social distancing guidelines from the continuing coronavirus pandemic are still an issue for many people. There are a number of approaches to take for filing your taxes while respecting social distancing, but the easiest is to simply do it yourself using tax software. And for cost-conscious filers, there are great free tax software packages available.
Now, what about that refund check?
6 things to do with your tax refund
Pay off debts
If you have any outstanding debts, particularly anything that might be considered high interest (anything above 8%), there's almost nothing you can do with your tax refund that's smarter than paying off that debt. This is particularly true if you're committed to not getting back into debt once it's paid off. Start by building a debt repayment plan, then use that for guidance as to what debt to pay off first.
Contribute to retirement savings
A healthy tax refund check can be a great boost to your retirement savings. You can use that check to boost your Roth IRA or, if you're a high-income earner, you can do a backdoor Roth IRA. You can also use this as an opportunity to bump up your contributions to your workplace retirement plan, as the tax refund check will help you to be sure that everything remains financially smooth.
Start an emergency fund
An emergency fund is a great safety net to keep you from falling into debt when the unexpected happens in your life, and your tax refund is great seed money to put towards an emergency fund. Simply open up a savings account at a bank, deposit your tax refund in your account and keep it out of mind until you need it in an emergency.
Save for a down payment
Many people have major life goals coming up that are costly. Whether it's buying a house, a car, or taking that much-planned trip around the world, putting your refund check toward that major goal can be your ticket to a potentially life-changing experience. Just deposit it in a savings account along with your other savings for that goal and take comfort in knowing that you're one step closer to achieving your big dream.
Invest in yourself
Improving yourself, particularly when it's beneficial for your career, is a great way to multiply the value of that check. Use the money to pay for a new professional certification or an online class, or even use it to help pay for pursuing a new degree. In some fields, there may be value in using the money to upgrade your professional wardrobe. If it's something that can truly improve your earning potential, investing your tax refund is potentially a very valuable move.
Spend a small portion on something purely fun
While it's a great idea to put all of your tax refund away for the future, it's undeniably true that it's tempting to do something really fun with it, too, and it can be hard to convince yourself to do the smart thing with it. One great solution is to put aside some small portion of it — say, 10% — for something fun, while doing something wise with the rest. If you get a $1,000 tax refund, put $900 toward something wise, then think of something truly fun and memorable to do with the remaining $100. That way, it feels good in the heat of the moment while also feeling wise in the long term.
3 things you shouldn't do with your tax refund
While those six options above are wise decisions for using your tax refund, they might not appeal to you. On the other hand, there are some options that are poor decisions you can make and that you should simply avoid. Whatever you do with your refund, skip these three things:
Spend it on something forgettable
It's not inherently a bad choice to spend your tax refund on something enjoyable, but it is a bad choice to spend it on something thoughtless. If you want to spend your tax refund on something fun, put some thought into it as soon as possible so that you don't watch it disappear on something frivolous and forgettable later. Consider things that will be deeply meaningful to you or provide lasting value in your life.
Spend it in risky investments
Investing your tax refund in solid investments such as stable, quality stocks or funds is always a wise choice, but investing in highly risky investments is tantamount to gambling. If you're eager to spend your tax refund in flashy investments that you're not financially prepared for, such as cryptocurrencies or high-yield junk bonds, take a step back and reconsider your risk threshold.
Spend it on an expensive hobby
Many people use tax windfalls as an opportunity to get started on an expensive hobby, not realizing that that hobby requires a lot of upkeep. They'll use it to buy golf clubs, for example, which sets them up to pay for pricey green fees — the set fee golfers must pay at a pro shop or clubhouse in order to gain access to the course — or they'll buy a video game console that will require lots of additional purchases. Before falling down that rabbit hole, ask yourself if what you want to buy is going to require many additional expenses to really get enjoyment out of it.
[This article was originally published on The Simple Dollar in December, 2020. It was updated in November, 2021.]