The annual ritual of filing taxes often culminates in a familiar scenario: the anticipation of a tax refund. The psychology of our tax system makes refunds feel like free money to be spent. The reality is that receiving a tax refund means that you've overpaid taxes and that your interest-free loan to the government is being paid back.
How will you put that to use? Here are some ideas.
Eliminate high-interest debt
One of the most financially prudent decisions you can make with your tax refund is to tackle high-interest debt. Credit card interest rates are some of the highest rates of any loan and should probably be prioritized. Attempting to save for investing or building up an emergency fund are often exercises in futility when carrying credit card balances. The interest rates are just too high. The closest thing you may have to a guaranteed investment is paying down high-interest debt.
If you don't have credit card debt, you may be considering paying down other loans next. Not all debt is bad, so look before you leap. Depending on the rate and type of loan, you might instead want to build up your emergency fund or investment portfolio. Exercise caution if you are considering making extra payments to a large fixed loan such as an auto loan or home mortgage because these loans require on-time payments for years to keep good standing.
Consult with us if you are considering paying down loans that aren't your credit card.
Build up your emergency fund
Financial emergencies can strike at any moment, from unexpected medical bills to car repairs. Worse yet, these emergencies can happen during times of slow business, job loss, or unpaid leave of absence. Having a robust emergency fund can provide a much-needed safety net during challenging times.
There are times when saving up a dedicated emergency fund might not make sense. For example, if you are already carrying credit card debt, it may be better to pay those down first and later swipe the card in emergencies rather than to continually pay their high fees.
Another time it might not make sense to build up a dedicated emergency fund is if you have sufficient investments of the right type. Holding too much cash may drag down the performance of your investments and make it take longer to achieve your goals, but it's important to do the math and hold the right portfolio to manage risk.
If you're wondering how large of an emergency fund to maintain, contact us to help you figure it out.
Contribute to an Individual Retirement Account (IRA)
Investing in an IRA is often a wise decision if you don't need your tax refund until retirement or later and you don't have more immediate uses because retirement accounts receive preferential tax treatment. For example: you won't pay capital gains tax when trading, and dividends on US stocks are tax-free. Depending on the account type and individual circumstances, contributions to your IRA may reduce next year's taxes, or you may be able to live nearly tax-free in retirement.
Be aware of IRA contribution limits to avoid tax penalties. If you want to continue saving for retirement beyond what is allowed through IRAs, don't miss the next section.
Invest Beyond IRAs
While building up your emergency fund and contributing to retirement accounts are crucial financial priorities, don't overlook the opportunity to invest in other avenues through a regular brokerage account. Whether it's saving for a down payment on a home, funding your children's education, or pursuing other medium to long-term financial goals, your tax refund can serve as seed money for future endeavors. Explore investment options such as stocks, bonds, or mutual funds and ETFs to further grow your wealth and achieve your financial aspirations.
We love helping people figure out how much to save, whether in an IRA or beyond, and guide them through investment decisions that fit their personality and accelerate their goals. Contact us if you're ready to invest.
Treat yourself!
A financial advisor saying that it's ok to spend some money on yourself? Yes, you read that right! We save and invest to live a better life.
It's hard to know on your own how much to save for retirement, buying a home or second property, etc. We have helped people, initially anxious about retirement and saving too much as a result, with a plan that gave them the liberty to spend and feel better.
Achieving financial stability doesn't mean depriving yourself of all indulgences; it's about striking a balance between responsible financial management and enjoying life's pleasures.
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