The average federal tax refund is $2,895 based on 2016 data. I could write an entire post about why you should change your tax withholding to ensure you don’t end up getting such a large refund, but we’ll save that for another day. A refund provides a great opportunity to make smart a financial decision. In this post, I’d like to highlight some different uses that would improve your financial life. Here they are in no particular order:
1. Shore up your emergency savings
You might have experienced unexpected car issues, home repairs or other financial emergencies in 2017. If you did, you probably leaned on your emergency fund to help pay for those unexpected expenses. You should generally aim to have 3-6 month’s worth of living expenses in a savings account as an emergency fund at all times. Using your refund to shore up your emergency fund may be a smart move because you can’t predict what could come up next. My favorite savings accounts right now are Ally Bank and CIT Bank (paying approx. 1.45%-1.55%).
2. Contribute to a Traditional IRA
It’s well known that many people are not saving as much as they should for retirement. You can use your tax refund to make a traditional IRA contribution and get a tax deduction for your 2018 tax year. Assuming a $2,895 refund and a 22% federal marginal tax bracket this could save you $637 in taxes! Make sure to check the IRA deduction limits before making the contribution.
3. Contribute to a Roth IRA
A Roth IRA is the opposite of a traditional IRA in that you do not get up an upfront tax deduction but all of growth of your contribution can be withdrawn tax-free in retirement as long as you follow the rules. This can be especially useful for young people and those who are in a lower tax bracket today than they expect to be in the future. A $2,895 contribution growing at 7% annually for 30 years could turn in to $22,037 of tax-free money in retirement!
4. Pay off credit card debt
There is no such thing as a guaranteed return, right? Think again! Paying off high interest rate debt is the surest way to “earn high returns.” Typical credit card interest rates are 15% or higher, so paying down those balances is usually a smart move. The interest on $2,895 at 15% would be $434 a year!
All of these ideas would be a smart use of your tax refund. You can even use some money for multiple different ideas listed here. In the end, a large tax refund gives you an opportunity to start fresh and make a sound financial decision. Lots of small, positive financial decisions over time can lead to a successful financial future!
Steven Elwell, CFP®
Partner, Vice President