Ramping up your emergency cash fund or IRA with your tax refund is a better option than spending it on a new smartphone or vacation.
Three out of four taxpayers received a refund of $3,000 in 2015. Although many consumers look forward to this windfall each year, it is not a “cause for celebration,” said Joe Jennings, a wealth director for PNC, a Pittsburgh-based financial institution.
“If you are receiving a large refund check, it actually means that you have loaned money to the government throughout the year and the next year the government is paying you back without interest,” he said.
Adjusting your withholdings is a good strategy if your refund exceeds $1,000. Changing the number of exemptions on your W-4 means you will net more income from each paycheck.
Bankrate.com, a North Palm Beach, Fla.-based financial content company, found that 31% of Americans who receive a tax refund this year plan to save or invest it. The survey revealed that 28% will use the funds to pay down debt, 27% will spend it on necessities like food/utility bills and 6% will splurge with a shopping spree or vacation.
Some consumers view the refund as a method of forcing them to save money each year or a way to pay down existing debt such as credit card balances with high interest.
Pay Off Existing Debt
Use your refund check to pay off as much as your credit card or student loan debt as possible since the amount of interest you are paying each month adds up quickly, said Jonathan Bochese, director of resolution services for Tax Defense Network, LLC, a Jacksonville, Fla.-based tax resolution company.
“The best use for any tax refund is to use it to pay off high interest revolving debts,” he said.
With the current low interest rate environment in money market funds and CDs, paying down debt is a no-brainer.
“If you can only make 3% on your investment and your debt is at a higher rate, pay off the debt,” said Carl Sera, a portfolio manager with Covestor, the online investing marketplace and managing principal of Sera Capital Management, a registered investment advisor in Annapolis, Md. “Don’t make it a habit to receive a tax refund, because it is money you have lent the taxing authority at a zero interest rate.”
Homeowners who do not have any other debt should pay down their mortgage by making an extra payment or two instead of stashing the refund in a savings account that is only receiving minimal interest, said David Reiss, a law professor at Brooklyn Law School.
“By doing so, you are making the equivalent of a pre-tax return of the interest rate on your mortgage,” he said. “If your mortgage has a 5% interest rate and your savings account has a 0.1% interest rate that is like getting a 4.9% higher rate of interest without taking any risk at all.”