How to spend a tax refund

tax refund

Hey, average American, what are you planning to do with the tax refund you are about to receive? So let's start with useful ideas for spending your tax refund for those in the first stage of personal finance and work our way up to those who are less pinched. Depending on which stage of personal finance describes your current financial situation, your tax refund can help you along if you plan carefully.

Before we go there, though, why are you getting a refund in the first place?

The Arguments Against a Big Refund

First, let's examine the reasons a person shouldn't get a big tax refund. (You've probably heard these statements before!)

  1. “You're giving an interest-free loan to the government!” The implication is that this is a stupid idea, but it isn't quite as helpful as the following arguments.
  2. “You're cheating yourself of cash flow!” If you receive a refund, extra money has been withheld from each paycheck. For some, this money can make a real difference in day-to-day living. In fact, it may be the difference between having to use credit or not. So there is merit to this argument, but it doesn't apply to my situation. I'm not that pinched.
  3. “That money could be invested at a high rate of return!” Now, this argument I grant to be convincing, and I don't have a rebuttal. Not only does a tax refund give your money to the government interest-free, it also deprives you of the opportunity to earn a return on your money.

If there are clear reasons not to get a tax refund, then why do it?

The Argument for a Big Tax Refund

I suspect that everyone who chooses to get a big tax refund does so for the same reason — it's a psychological trick. It's like a self-imposed, forced savings plan. It might be the only way your emergency fund gets started.

Okay? Now back to our options.

How to Spend a Tax Refund (Wisely)

1. Don't spend a single penny before the money arrives in your bank account.
Don't charge something on credit cards; don't promise to spend the money; don't put a deposit down with the rest due the day you expect the refund. You never know what unexpected expense might cause you to be staring down a final payment or contract fulfillment without anything left in your bank account but hope.

2. Don't go on a spending spree after the money arrives either!
Seeing that nice chunk of change in your bank account could put you in the mood to splurge. Instead, deposit your refund directly into your high-yield savings account until you can make a list of all the things you have been wanting or needing over the last year. Then prioritize these items and start making a plan for these funds with the next suggestion.

Related >> Which Online High-Yield Savings Account & Money Market Account is Best?

3. Make a budget or spending plan before you do anything else.
It's amazing how quickly a refund can disappear without a plan. So once you know how much your refund will be, create a spending plan by listing all your income, fixed expenses (bills you have to pay every month), and your debts. Think ahead, too, about any large expenditures that might be on the horizon. With everything listed in one place, you get a better picture of how to make the best use of your refund.

4. Apply the refund to one of your debts.
Do you have credit card debt? You may want to negotiate your credit card balance first. Then, use the refund to pay off the card or make a dent in a card balance. Of course, you can apply the refund to a car loan or student loan debt as well. Pick the debt that bothers you most, or, if they all irritate you equally, pick the one with the smallest balance or the highest interest rate — whatever will motivate you the most to continue your cause to get out of debt.

5. Build your savings.
A refund is the perfect seed money for the emergency fund you have been hoping to start. College savings for your child? Maybe you need to start saving for a replacement vehicle? Are you planning to get married or have a baby? A healthy savings account balance can help you achieve your goals and work toward financial independence, so build your savings with all or part of your refund.

6. Buy things that will save you money.
If your expenses and savings are well covered, you might consider buying things that can help you save money in the future. Think about upgrading windows or adding new insulation (to save on energy costs), get a couple of bus passes or another bulk purchase of something you use very frequently. Maybe a bike could turn your commute into a workout or eliminate the need for a second car, thereby reducing your insurance bill. Maybe you can buy half of a cow from a local farmer, saving you tons all year on quality meat — or maybe a chest freezer to make that possible. Have a baby? Buying a stash of cloth diapers can save you money over time — and save the environment as well.

7. Buy things that will make you money.
Before I talk about traditional investments, I want to encourage you to think about a different way to develop a good return: Invest in yourself. Can you use your refund to help you learn different skills, take an interesting course or go to a conference that can help you increase your income?

8. Invest it.
Use your refund to start funding your traditional or Roth IRA.

Maybe you want to get your own index fund. If all your other goals are met and you are on solid financial ground, you could even use a little bit to buy a few individual stocks just for fun.

If you truly are trying to save with the money, the U.S. government has an option for you: buying U.S Savings Bonds. Instead of getting a cash refund, you can designate up to $5,000 of your refund to be delivered in actual paper bonds issued in your name.

I Bonds are savings bonds that are indexed for inflation. The earnings rate on an I Bond has two components:

  • The first is a fixed rate that remains the same for the life of the bond.
  • The second is the variable “semi-annual inflation” rate. Twice each year (on May 1st and November 1st), this rate adjusts based on the current inflation rate.

The fixed rate and the variable rate are combined to get a composite rate, which is currently 1.48 percent. I know this is a lot of gibberish. All you really need to know is that I Bonds are a safe place to put your money so you don't have to worry about it losing value to inflation.

Because of this, I Bonds are an attractive alternative to a savings account, especially now. They offer higher rates of return, and I Bonds are state- and local-income-tax exempt. (Federal income tax on I Bonds can be deferred until the bonds are cashed in or stop earning interest after 30 years.)

One drawback? I Bonds are not as liquid as high-yield savings accounts. You can cash them out whenever you want; but if you do so before five years, the bond is subject to a three-month earnings penalty. It is sort of like breaking a certificate of deposit early (which is another investment option some might consider.)

Related >> Best CD Rates | Certificate of Deposit Rates

9. Make your life easier.

One of my retired friends has been saving for years and has always tried to be responsible with her money. While she was still working, whenever she got a raise, she increased her contribution to her retirement accounts.

Recently, I met her for lunch shortly after she lost both of her parents. “Once we sell their house, we'll have a small inheritance. I've always tried to save, but this time,” she said in a firm voice, “I decided I don't really need to save any more money. No, this time, I want to use the money in a way that makes my life easier.”

She has a point. We have hardwood floors in most of our house and, while I would eventually like to have a long wool runner in our entry area, I have been making do with a hodgepodge of rugs that are mismatched and cheap-looking. Since they aren't substantial, the little feet that walk on them all day long shift those rugs all over. It drives me crazy. Using part of our refund to buy the rug would definitely make my life easier.

10. Spend 5 percent or so on something nice.
Go out to eat with your family (once). Buy yourself comfortable shoes or some cool, new gadget. (You probably have a favorite splurge.) If you have been wanting to support a local artisan and, again, all your other goals have been taken care of, you may want to use your refund for that too. Work to build strong ties in your community by purchasing groceries for an elderly neighbor, giving a gift to a dear friend, or helping a college student purchase books.

As you can see, there are a multitude of ways to spend your refund. Use it wisely and it could motivate you to even greater financial success!

If you are expecting a tax refund this year, how do you plan to spend it? Was it a fluke, or is getting a refund part of your strategy?

[Editor's note: An earlier version of this article appeared on February 2, 2012. The original comments were retained in case they provide value to the reader today.]
More about...Taxes, Budgeting, Planning

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