We can all agree that it’s never fun to find out you owe money when filing a tax return. As a CPA, I hate sharing the bad news with my clients of a 4- or 5-figure tax bill, even if it was because they earned more money throughout the year.
For some of my clients who opted to have more taxes withheld throughout the year, they may receive a refund in March or April. This can be a source of “savings” that they might not otherwise have had the discipline to save for throughout the year. According to the IRS, the average refund for the 2017 filing season was $2,763, which is nothing to sneeze at.
So, if you are among the lucky ones to receive a substantial tax refund, what should you do with the money? Here are some ideas.
Best ways to use your tax refund
When it comes to windfalls like a significant tax refund or annual bonus, you might want to consider a balanced approach such as putting 50% towards debt payments (if you have any), 30% towards savings, and 20% for fun and splurges.
- Pay down debt. Making an additional principal payment towards outstanding debt: whether it’s a credit card, mortgage, student loans, or other consumer debt will help you become debt free a little bit sooner. Plus, this will help you save on interest expense.
- Pad your emergency fund. I recommend having at least $1,000 set aside for the unexpected trip to the ER, major car repair, deductibles for insurance policies, or other disasters. After that, it’s recommended to have 3 to 6 months to cover living expenses if you were ever without a job. If you’re self-employed, you may want to work towards 12 months of living expenses as your business grows or if your income varies throughout the year.
- Contribute to a retirement account. You can do double duty with your refund by saving for the future while also saving a little bit on taxes. Depending on your adjusted gross income, a contribution to a Traditional IRA could be deductible and lower your taxes for that year. On the flip side, contributing to a Roth IRA is made with after-tax dollars, and the funds can be withdrawn tax-free during retirement. Or if you’re self-employed, you might consider contributing to a Solo 401(k), SEP IRA, or SIMPLE IRA. You should talk to your tax advisor to learn more about these and other retirement savings options.
- Save for a down payment on a house or car. If you’re looking at putting down 20% for a mortgage, your tax refund might help you make some headway on saving for this goal. Personally, if we receive a return, it’s probably going to be put toward a new minivan because our family is about to outgrow one of our cars.
- Buy life insurance. If you have financial dependents, then you probably need life insurance. There’s no better time than the present (or after you’ve gotten money back on your tax refunds) to buy a life insurance policy and help financially protect your loved ones.
- Invest in your business. If you’re self-employed, you may want to consider investing in a new computer, updating your website, hiring, or buying additional inventory. Since qualifying business expenses are also deductible, using your tax refund this way can help lower your tax bill for the following year. Just be sure to invest in something you really need.
- Invest in yourself. This could be personal or professional development. And, if you’re self-employed, professional development can then be a business deduction.
- Save for your kids’ education. If your emergency fund and other big financial goals are on track, you may want to consider contributing to a 529 plan for your kids. Starting in 2018, 529 plans can be used for primary and secondary education, in addition to college.
- Have some fun and go on vacation. Experiences are great splurges for a number of reasons. Studies have found that people are happier and enjoy their purchases more when they’ve saved up and planned to buy something long before they make the purchase. Even better, buying experiences such as vacations or theater tickets can lead to even longer-lasting happiness because those experiences create memories, and you can build stronger relationships with family and friends.
- Spoil yourself. Use a little bit of your return as a reward. Maybe it’s a massage, new haircut, the latest tech gadget, or a fancy date night. There’s nothing wrong with spending a little money on yourself.
- Upgrade practical things like your wardrobe, workout gear, appliances, or a new grill (anything in the name of a good steak.)
- Tackle a home improvement project. In the past, we’ve used our tax refund on projects like installing new windows, a brick patio, a tile backsplash, or even knocking down a wall. Using your tax refund to help jumpstart some work around the house can be very beneficial (not to mention, productive). There’s no guarantee you’ll recoup the full cost when selling your home, but the enjoyment derived from these improvements can be well worth it.
- Prepay a big expense. Do you have some significant expenses on the horizon, like property taxes? Pay for them with your refund now, especially if they’re typically due during a lean time of year.
- Give some money away to a charity. Those who are charitably-minded may want to use their tax refund as a way to make a larger donation to their favorite non-profit organization. Perhaps it’s the local children’s hospital or to other charities who help women start businesses, send children to schools, or provide clean water and improve health in developing countries. Depending on the type of charity, there may be some additional tax benefits.
- Buy a gift for someone or pay it forward. Maybe your kids’ teachers have a wishlist of things their classroom needs. If so, think about buying them something like additional school supplies, technology, or books.
Now that you have a few ideas on how to spend your tax refund, how can you adjust your tax withholdings or estimated tax payments to either increase or decrease your tax refund?
Review your tax withholdings
If you work as an employee and receive a W-2, take a look at your W-4 and current tax withholdings. Keep in mind, in 2018, there are major changes in the tax laws including credits and deductions, so the tax withholdings based on your current W-4 might not be appropriate. Not to mention, your filing status and family size may have changed since you last completed a W-4.
If you claim too many allowances, you may not have enough income taxes withheld during the year. If you tend to owe additional taxes, and would prefer to get a refund, consider having additional taxes withheld from your paycheck. The IRS has a great tool on their website that can help you perform a quick “paycheck checkup.”
Before you receive your tax refund, think about how you’ll spend that extra money. It’s okay to splurge a little, but your future self will also appreciate some smart spending strategies.
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Cathy Derus is the founder of Brightwater Accounting and Brightwater Financial. As a CPA and financial planner, she helps individuals and business owners eliminate stress and worry over taxes, business finances, and more. Anyone can throw numbers into tax software. She’s here to help you make sense of those numbers and create a better financial strategy for your business and life. Her expertise has been featured in Entrepreneur, CNBC, US News & World Report, The Washington Post, Real Simple, and Cosmopolitan.
Haven Life Insurance Agency (Haven Life) does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
Haven Term is a Term Life Insurance Policy (ICC15DTC) issued by Massachusetts Mutual Life Insurance Company (MassMutual), Springfield, MA 01111 and offered exclusively through Haven Life Insurance Agency, LLC. Not all riders are available in all states. Our Agency license number in California is 0K71922 and in Arkansas, 100139527.