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Every year, the IRS issues over $300 billion in tax refunds to more than 100 million Americans — close to $3,000 per taxpayer, on average.
While it would be tempting to blow at least some of this windfall on indulgences like a vacation, spending your tax return wisely can maximize its value.
Richard Cordray, director of the Consumer Financial Protection Bureau, recently noted that more than 70 million Americans have no emergency savings, and many others are paying down high-interest debt.
“As we approach the upcoming tax season, we know that a tax refund may be the single biggest check some consumers will receive all year,” Cordray said. “The refund is a good opportunity for individuals to pay down high-cost debt or set aside even a small amount of savings to help reach their financial goals.”
Here are eight smart things to do with your tax refund that can have long lasting financial benefits.
Pay off high-cost debt
If you have credit card debt that you’re paying 15, 20, or 25 percent interest on, using your tax refund to pay it off is like investing your money and getting an unusually high rate of return.
If you’re paying down a $3,000 credit card balance at 20 percent interest by making minimum payments of $120 a month, it will take you 10 years to retire that debt. You’ll pay more than $1,900 in interest, or nearly $5,000 in total. Zap that debt with your $3,000 tax refund now, and that $1,900 stays in your pocket.
In general, personal finance experts advise that you pay down debts with higher interest rates first. If you have student loans that carry lower interest rates — particularly subsidized government loans — you don’t necessarily need to sweat those if the monthly payments are manageable.
But if you’ve got older student loans that carry higher interest rates — particularly graduate school debt — those may rank higher on your list of priorities. If you can’t pay off your high-interest student loans outright, consider refinancing them at a lower rate.
Establish a rainy day fund
If you don’t have a reserve fund with enough money set aside to cover three to six months of expenses, you could be asking for trouble. An unexpected medical emergency or job loss might leave you with little choice but to borrow money at high interest rates in order to take care of basic living expenses.
The money you set aside for your rainy day fund should be accessible at the drop of a hat, so think twice about investing it in stocks, bonds, or certificates of deposit. A money-market or savings account will allow you to earn a little interest on your rainy day fund, but using your checking account may help you maintain a minimum balance needed to avoid fees.
Invest for the long run
If you’ve already got enough savings to cover three to six months of expenses, consider long-term investment opportunities. If your employer offers a 401(k) or other retirement plan, many financial advisors recommend taking full advantage of employer matching dollars. Remember that money that you contribute to a 401(k) is pre-tax income, meaning you get more bang for the buck.
Invest in yourself
Going back to school to earn a higher degree or learn new skills can pay off by making you more employable and increase your earning power. Even a small tax refund can pay for many continuing education courses, and a larger one can get you started on the path to completing a certificate or degree program.
Invest in your children
A 529 plan lets helps you grow savings that you set aside for college and other post-secondary training for any designated beneficiary — a child, grandchild, relative, or friend — even yourself. While the contributions you make to 529 plans are not tax deductible, gains you make on investments (the plan’s earnings) are exempt from federal taxes — and generally not subject to state taxes, either– when used for qualified educational expenses. Qualified expenses include tuition, fees, books, room and board — even computer technology and equipment now qualifies.
You can sock away up to $14,000 a year in each 529 plan you create without tax consequences. Considering how fast tuition and other college expenses are growing these days, a 529 plan could help a loved one graduate with as little student loan debt as possible.
Invest in your home
Many home improvements — particularly those that result in energy savings — can save you money in the long run. Energy efficiency projects that deliver the biggest bang for the buck include insulation and weatherization, and installing a programmable thermostat. According to the U.S. Department of Energy, the typical U.S. family spends at least $2,200 a year on home utility bills, and could trim up to 25 percent of that cost by employing tips in its Energy Saver Guide (many of the tips in the guide can be employed by renters, too). Many states offer weatherization assistance programs.
Save for a big purchase
If you’re yearning for a vacation or know that you’ll soon be facing a big expense like a new roof for you house, you can save a lot by planning ahead and paying cash instead of borrowing money to pay for it.
Protect your assets
If you have only the minimum required personal liability coverage for your auto and homeowners insurance policies, your assets could be vulnerable if you’re hit with a legal judgment on behalf of someone who’s injured in an accident. California, for example, requires only that drivers carry bodily injury liability insurance of $15,000 per person, with a total of $30,000 in coverage per accident for injuries sustained by others, and $5,000 in property damage liability insurance. A few hundred dollars in extra insurance premiums can provide up to $1 million in additional coverage.
One last thought. If you find yourself cashing a big tax refund check every year, you might want to think twice about whether that’s a good thing. Getting a tax refund means that you let Uncle Sam withhold too much from your paycheck. While you’ll eventually get that money back, you’re essentially giving the government an interest-free loan while it holds on to it.
One way to adjust your witholdings is to increase the number of exemptions you enter on the W-4 on file with your employer. You can use the IRS withholding calculator to make sure you’re claiming enough exemptions.