Tax season is officially upon us. The 1099’s have gone out, and the IRS has started accepting returns. Like many taxpayers, you are hopefully looking forward to a nice refund this year (because no one wants to owe anything, right?).
Many people start dreaming of how they will spend their windfall before they even file their taxes. An expensive vacation, home renovation, or new furniture may be on your wish list.
Your tax refund is YOUR money, and you should spend it how you like. You earned it, after all. However, we wanted to offer some practical and pragmatic suggestions on what to do with your tax refund, especially if you are hoping to invest in a new home in the near future. A vacation might be fun in the moment, and will certainly create lasting memories, but a home is the anchor for your future wealth. So you decide, which is best for you given your situation.
Here are four suggestions for wisely investing in your future with your tax refund.
Set Aside an Emergency Fund
Financial guru Dave Ramsey, among other advisors, strongly advocate for setting aside an emergency fund as the very first step toward financial freedom. There is certainly room for debate on whether the first step should be the emergency fund or paying down debt, and neither position is wrong. However, if an emergency arises and you don’t have funds set aside, you may find yourself going into more debt to weather the storm.
A recent Bankrate survey found only 40 percent of Americans have savings that could cover a $1000 emergency expense. This means that 60% of Americans are vulnerable in the event that something unexpected happens.
In order to successfully start an emergency fund, consider putting the money in an online savings account or money market fund, which tend to have higher yields than traditional brick and mortar banks. Put your money to work earning interest while it’s sitting there, rather than hiding it in a cookie jar or under the mattress!
Another trick is to keep it in an account that is not linked to your general spending accounts. It’s too easy to transfer money between accounts and tap that emergency fund for non-emergencies if it’s linked to your checking account. Keeping it completely separate will at least slow you down, and force you to think about whether or not you are spending it on a true emergency.
Pay Down Debt
If you are thinking about purchasing a home in the future, then paying down debt needs to be a high priority. And truly, even if you aren’t buying a home soon, it’s still a good idea for your financial health. Excessive debt can negatively impact your ability to get approved for a mortgage, and it can prevent you from achieving financial security.
High-interest credit cards are by far the worst kind of debt. If you are paying the minimum payment ever month, it can take you years and thousands of dollars in interest to pay it off – and that’s if you don’t add to the balance. Installment debt, such as car loans, are marginally better, because they have fixed end points and lower interest rates. So you focus should be on eliminating high-interest, revolving debt first.
If you are like many consumers, you may have multiple credit cards with balances, so how do you know which to pay first? There are a couple schools of thought:
- The snowball method. With this approach, you pay off the smaller balances first. Psychologically, this is very motivating, because you experience the sense of accomplishment associated with paying off accounts in full. Once you pay off one account, move on to the next smallest balance, and keep going until all your debt is paid off.
- The avalanche method. With this approach, you rank your credit cards by interest rate, and pay off the highest interest rate account first. It may take longer than the snowball method if the balance is larger, but you will save more money in the long run by eliminating the highest interest rate first.
Save Toward a Goal
If you are saving for a down payment on a new home (or for any reason), you can accelerate your savings by adding your tax refund to it. As with your emergency fund, you definitely want to put your special-purpose savings funds in an interest-bearing account that you can’t tap easily through your primary spending accounts.
If you think it could be a year or more before you need the money, you may be able to park some or all of it in a 1-year CD for a slightly higher interest return. Stay away from long-term CDs though, because there can be stiff penalties if you need to remove the money before the term is up, and the interest rates may not be worth the headache.
Whichever savings vehicle you choose, the main point is that your cash is working for you and growing as much as possible.
Save for Retirement
You can park your tax refund in an Individual Retirement Account (IRA) up to the contribution limit. There are certain advantages to this, as your contributions may be tax deductible (depending on the type of account), and you can invest the money to grow tax free. With a traditional IRA, ou will pay taxes when you start withdrawing, ostensibly at a lower tax rate because you’ll be retired. With a Roth IRA, your withdrawals are tax free, but your contributions aren’t tax deductible.
As a general rule, it doesn’t make sense to put your tax refund n an IRA if you haven’t paid off your debt yet, or if you are not maximizing your employer contributions. The interest you are paying your debt will offset any earnings you may make in the IRA. Your contributions to a 401(k) or other employer retirement account are taken out prior to taxes, which reduces your taxable income. Plus these are often matched by employers, so you want to be maxing out your contributions to that account before you start setting aside separate retirement funds in an IRA.
These are just a few ideas on how you put your tax refund to work improving your financial future. However, don’t feel like you have to choose any one option. You can divide your tax refund among multiple options, including setting aside some of it for fun. You are more likely to continue saving and paying off debt if you allow yourself an occasional splurge.
When it comes to buying or selling your home, we are here to help answer any questions and guide you through a better understanding. Please do not hesitate to contact us at firstname.lastname@example.org or phone us at 202.800.0800.