A tax refund—while good to get—isn't really extra money. It's money you earned that you didn't have the use of during the year.
A refund means you had too much withheld, and, in effect, gave Uncle Sam an interest-free loan with money that could have been in your own pocket.
Now you need to decide how to use this money wisely—and how to avoid getting a refund next year.
With this year's April 17th deadline for filing taxes just ahead, I have a question for you: Is getting a tax refund always a good thing?
A lot of people look forward to getting a refund rather than paying taxes. Okay, getting money rather than giving it is a plus. But look a little closer. If you're getting a refund, the fact is that you had too much withheld and overpaid your taxes during the previous year. And by having too much withheld, you actually reduced your take-home pay and, in effect, gave Uncle Sam an interest-free loan with money that could have been in your own pocket.
Looked at this way, a tax refund—while good to get—isn't really extra money. It's money you earned that you didn't have the use of during the year. So now that you do have this hard-earned cash in hand, what will you do with it?
Behavioral economists point out that people think differently about money depending on how they get it. For instance, when you think of a refund as a kind of windfall, you might be tempted to blow it all on something extra. But when you realize that it's the final payment of your yearly salary, you might be more likely to use it wisely. That doesn't mean you can't have some fun. It just means you might want to carefully consider the best use of this money—because no matter where the money came from, the value of the dollar is the same.
Five smart ways to use your tax refund
Of course, what you decide to do with this money will depend on the size of your refund and your personal situation. Broad categories might include paying down debt, saving and investing, or reaching personal goals. But to me, to make the most of this money, you need to get specific. Here are five suggestions I'd put at the top of the list.
- Pay down "bad" debt—Are you carrying credit card balances? Do you have a high interest car loan? This type of expensive, nondeductible consumer debt—considered "bad" debt—is best to get rid of as soon as possible. This could be a great use for your tax refund. If you have that type of debt under control, but are struggling to pay off student loans, this could be a good time to make an extra payment or two. While a student loan often falls in the "good" debt category, getting out of debt completely is a positive goal that will free up future money for other uses.
- Put money aside for emergencies—It's always hard to carve out money for an emergency fund when there are so many other obligations, but you'll thank yourself if you're ever in a bind. Don't let something like a layoff or health problems totally derail you. If you haven't started an emergency fund, do it now. Or add to an existing one. To be safe, you should try to keep enough cash to cover three to six months of expenses in an easily accessible place, like a savings account.
- Add to your retirement savings—If you don't have an IRA, consider one now. Even if you have a 401(k), an IRA is a great way to supplement your retirement savings. You can open an IRA for as little as $500 (sometimes less) and make yearly contributions of $5,500 ($6,500 if you're 50 or older). If you qualify for a Roth IRA, consider starting there—especially if you're in your early earning years.
- Make an HSA contribution—With healthcare costs a universal worry, contributing to a health savings account (HSA) can be a great way to plan ahead. To open an HSA, you have to have a high-deductible health insurance plan. Check to see if you qualify. The benefit of an HSA is that you get an upfront tax deduction for the contribution. Plus, withdrawals for qualified medical expenses are tax-free. On top of that, any balance in the account continues to grow tax free year after year and can be used for health care expenses later on in retirement. (If your plan provides investment options, consider a stock mutual fund or exchange-traded fund for the money you won’t use for five years or more in the future).
- Treat yourself—Now comes the fun part. No matter what practical use you have for your refund, it’s okay to set aside a little to treat yourself and your family. But make it something you really want, perhaps something you'd already started to save for. Remember, this is money you've earned. Think of it as a reward for your efforts.
How to make sure you don't overpay next year
If you got a big refund this year—and even if you didn't—because of the new tax law that went into effect in January, you may want to review your withholding to make sure you're not over or underpaying. The IRS has released an updated withholding calculator to help taxpayers check and update their withholding. You may also want to consult with your tax advisor. You can then download a new Form W-4 and complete and submit it to your employer.
You don’t have to wait until the end of a tax year to make a change. You can give the new W-4 to your employer at any time. But do make a change if necessary. After all, a big refund means you overpaid your taxes. Is that something you really want to do?
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