Whoo hoo! Ready for a nice, fat refund check from Uncle Sam? Taxpayers received, on average, $2,696 in refund money last year, the Treasury Inspector General for Tax Administration reports.
All too often that extra money makes people splurge, even while they imagine they’re saving it. How do you make sure this year’s windfall makes your life better long term?
Put it in your paycheck
First, remember that your refund isn’t a gift. You earned it but chose to bank with the Treasury Department instead of taking it in your paychecks.
This year, wouldn’t an extra $225 a month make your life a bit saner? If so, do this:
- Gather your pay stubs and last year’s income tax return.
- Use the IRS withholding calculator to learn if you should change the tax amount withheld from your paychecks. Read the instructions carefully to see if adjusting is a good idea for you.
- Fill out IRS Form W-4, adjusting your withholding amount.
- Bring the completed form to your employer’s payroll department.
Now for nine ways to make life better with that refund money:
Idea No. 1: Pay down high-interest debt
High interest rates can lead to devastating debt. Eventually you can end up with payments so large that it becomes difficult to do more than pay the minimum required each month. That’s a losing proposition, Stacy Johnson says:
Suppose you’ve got a $10,000 credit card debt and pay 15 percent interest. If you pay $250/month, you’ll pay the card off in five years and pay about $4,000 in interest. But lower the interest to 10 percent, and the same $250 will pay the card off in only four years, with an interest tab of $2,215. The lower rate saves you nearly $2,000 and a year of debt.
Here’s the most rational thing to do with a windfall: Use it to pay down, or pay off, your debts that have the highest interest rates.
Think of this way: Paying off a debt with a 15 percent interest rate is like earning 15 percent, risk-free and tax-free. That is virtually impossible to find these days.
When you’ve paid down your debt, don’t stop. Your goal should always be to improve your life. Charging and borrowing leads you in the opposite direction. If credit-card debt, payday loans or other high-rate debts have been a problem for you, use this moment to escape the cycle. Choose from the trustworthy sources of free credit counseling and get help so your 2014 refund improves your life permanently.
Idea No. 2: Pay off small debts
Paying off high-rate debt first makes sense, but it may not work for you. Some people get more motivation from demolishing smaller debts first.
U.S. News and World Report explains why this strategy can make good financial sense: “[I]f you can focus enough to pay off your debts in a relatively short amount of time, the higher interest rates on other accounts may not add up to much extra money.” We’ve said the same in posts like “The Best Way to Pay Off Debt.”
Of course be careful here, too, not to run up new debt and dig yourself back into the same hole.
Idea No. 3: Fatten your emergency fund
You are debt-free? Bravo! In that case, strengthening your financial safety net may be the next best use of a tax refund.
Opinions differ on how much to save for emergencies. Many experts advise keeping enough money to cover your expenses for six months. But maybe the question is: If you lost your job, how long could you expect to be unemployed?
The length of time people are unemployed typically depends on what the economy is like when they lose their jobs.
That’s obvious, I suppose, but it tells you the goal for your emergency fund may vary: smaller in fat times, larger in lean ones. The size of your fund also may vary depending on how hard it is to find work in your field, or how stable your current job is. And your savings should be greater if you’re older because it often takes older workers longer to find work.
AARP’s 2014 analysis of data from the Bureau of Labor Statistics on the average length of unemployment for workers found the following:
- Age 54 and younger: 34.7 weeks to find a job (almost nine months).
- Age 55 and older: 45.6 weeks (nearly a year).
I know someone who lived on savings for a couple of years while hunting for work during the recession. He’d set aside a big bonus so he did OK, but the experience made such an impression that he now tries to keep a year’s worth of savings for an emergency.
Idea No. 4: Save for retirement
Retirement savers are a lot like professional football players, says Money Talks News writer Maryalene LaPonsie. They keep their eye on the clock, for instance. And they accept that you can make progress a few yards at a time. Read her six tips from the gridiron for retirement savers.
Idea No. 5: Save for college
Whether it’s your education or that of your kids, apply your refund check to a college savings plan or 529 plan that offers tax benefits in addition to saving for college.