Finally, it’s here. That little piece of paper with the big numbers on it from the US Treasury: the check that represents your tax refund. Or perhaps you’ve logged into your bank account and seen, to your delight, that your checking account’s balance has just doubled. Congratulations! You feel instantly richer.
If you’re like most of us, that immediate jolt of pleasure is followed instantly by a longer-lasting period of uncertainty. What should you do with all this money? A survey by the Principal Financial Group gives us a hint of what people say they intend to do.
The firm polled more than 1,110 workers, working at medium- or small- sized businesses across the country. Of those that were expecting a tax refund, 53% said they planned to save or invest it; 19% intended to pay down long-term debt, such as a mortgage. Only about 18% admitted they would use part of that refund to spend on a vacation or to buy the latest smartphone or other consumer gadget.
But behavioral finance – the weird ways in which money makes us do things that aren’t in our best interests, or distorts our perception of reality – tends to kick in once the money actually is in the bank. The average tax refund last year was nearly $2,700, up 1.5% from 2013; that’s a lot of money to arrive suddenly, all at once, and to be not spoken for by any single part of your household budget. Having all that money suddenly available for you to use is a temptation to do just that – use it.
One way to bypass a splurge, suggests Robert Schmansky, a Certified Financial Planner and founder of Clear Financial Advisors, in Detroit, is to use the IRS’s Form 8888 to have your refund directly deposited to your savings account. “If it doesn’t touch your checking account, you are far less likely to feel the urge to spend it,” he notes.
And while it is nice to get a big cheque, something to ponder, when you’re filling out IRS documents, is the fact that this is your money that the government is returning to you, having deducted it from your earnings over the course of the year. Wouldn’t it be even better to stop making large loans to the US government over the course of the year, in the form of higher than required tax payments? Especially since you won’t see the Treasury paying you interest for the use of your cash.
So, if your refund is significantly larger than the average, or if you routinely get refunds that are a hefty percentage of your total income sit down with your accountant or your human resources, and figure out how to adjust your withholding. Sure, it may be lovely to get a $5,000 annual “bonus”, but unless you are extraordinarily bad at saving throughout the year, and extraordinarily disciplined when it comes to steering all of your tax refund straight into an IRA account or some other retirement savings vehicle, this is far from being the smartest way to save.
After that, the next priority should be to bolster your emergency savings. “Add some cushion to your cushion,” recommends Steve Repak, a former Army sergeant who tries to instill the same kind of discipline in the clients of his Charlotte, North Carolina-based financial planning business, that he once drilled into the soldiers under him. “Your car’s transmission will go out, or your pet will swallow a golf ball, and you need short term savings to cover these types of emergencies.”
Replenish emergency cushion
Your tax refund is the ideal way to replenish your emergency cushion, if you’ve had to draw on it over the course of the last year, or to boost it further. Repak recommends holding at least three months’ worth of monthly expenses, and as much as six, if you can manage it, in this account. The more you can put in this account, the less you’ll worry when you crack a tooth and realize that the deductible for a crown is 50% of the (very high) cost.
Save, of course. Ideally, this is something you should be doing throughout the year, and for most of us, socking away a tax refund in our retirement savings plans isn’t going to be enough to compensate for a failure to put aside even $100 a week throughout the year. And if you’re putting money into an IRA, you can actually reduce the amount of tax you owe, instead of funding your retirement savings with after-tax dollars – especially after-tax dollars that you’re getting back from the government after it has held on to them for many months. But it’s better than nothing, and if you’ve fallen behind over the course of the year,
But if you don’t have to use your tax refund to pay off that high-interest credit card bill that has been nagging at you for months, to purchase a new air conditioner before the summer heat wave hits, or replace the car’s tires after it has emerged the worse from its encounter with too many potholes this winter, there are still other options available to you that don’t involve splurging on consumer electronics or blowing the whole refund on a vacation.
Let’s say that you know by refinancing your mortgage, you could save a healthy amount each month, but you’ve been avoiding doing so because of the fees and closing costs you’d have to pay. Well, now you’ve got the refund that you can use to cover those expenses – and you’ll be reaping the benefit of the lower monthly mortgage bills every month going forward.
Renovations, charitable giving may help for next year
There are other ways to invest your refund money in your future, too. Does your house need improvements that are likely to increase its value? Perhaps that refund money will cover the cost of the new kitchen cabinets you need, making the cost of a complete kitchen renovation more manageable. Have you been thinking about taking an accounting class? A language class? Some other course that would increase your skills or help you prepare yourself for a new career? Well, now you have the money to pay for it – and those costs may even prove to be tax deductible in a year’s time.
Charitable giving is something else that often ends up coming low down the priority list for some of us; we write checks at the end of the year, with the money that we set aside for that purpose or that we have left over. But assuming that there isn’t a pressing need for you to use that money to fill big financial gaps at home, this could be a great time to sit down and think about your philanthropic priorities without feeling under pressure to make decisions before year-end giving deadlines. And yup, those gifts will be tax deductible, too.
And while a tax refund isn’t an excuse for a shopping spree, a big party, or upgrading your car (if you’re happy with the one you’ve already got and it’s still running fine) just for the hell of it – that doesn’t mean you can’t have some fun. Just keep it in proportion: a $200 evening out after a $2,000 refund is great; spending $3,000 on a cruise after getting a $1,500 refund is something most advisors will find more problematic, unless you also just won the lottery. “People who have balance in their lives are happier,” Repak says.
