Now that tax season (aka paperwork hell) and the unusual tax deadline of April 17th have passed, you, like most Americans, are probably anxiously awaiting your refund. Or perhaps you’ve already received it and have been daydreaming about all the fun, frivolous ways you could blow it. Not so fast, my friend.
Why do you get a tax refund?
Before you book that trip to Europe or go to your local Home Goods and leave having “accidentally” bought enough to redecorate your entire apartment (you know who you are), let’s remind ourselves what a tax refund really is: a refund. Your tax refund is not “free money”. One person does not “unfairly” get more back than anyone else. No. You get a refund because you paid the government more tax throughout the year than you needed to.
While the government had your money, it was being used to fund various projects or was even invested to earn the government more money. Now, come tax time, it’s being returned to you, but without any share of that additional wealth (nor even so much as a thank you!). By paying in too much throughout the year, you have effectively loaned the government money interest-free, money that you could have been using to do any number of things: pay bills, save for retirement, invest, go on vacation, have a date night every month… The list is endless.
Your tax refund is not “new” or “extra” money
Like many people, I used to think of my tax refund as “new” money. Entering my W-2 information into the tax prep software was like pulling the lever on a slot machine, crossing my fingers, and shouting “Mama needs a new pair of shoes!”. I never had any idea how large or small my refund would be, nor why I was getting money back. One year I even had to pay in and was frustrated because I didn't understand what I had done wrong.
Either way, I, like many of you, viewed getting a refund like finding a $100 bill on the sidewalk - winning! But now that I know why I’m getting money back (because I unknowingly loaned it to the government for a year), I don’t view my refund as shiny money on the sidewalk anymore. No, now I realize it’s actually more like finding a crinkled up $100 bill in my jeans pocket that’s been there the whole time, but has gone through one too many wash cycles and is now torn and missing a corner. Sure, I can still use it, but it would have been nice to know that it was there, crisp and ready to use from the get go. Just saying. (End rant.)
So what can you do about it?
If you’re regularly getting a large tax refund, the first thing you should do is check your withholding settings on your W-4. A W-4 is a form you filled out when you first started working for your employer. The boxes checked tell your employer how much federal tax you’d like withheld from your paycheck. As your circumstances change, your withholding selections may need to be adjusted as well. Consult a tax professional and fill out a new W-4 if necessary.
In the meantime, commit to spending your refund (that money you lent to the government) wisely. Uncle Sam used your dollars to make more dollars, so why shouldn’t you? Plus, after not having that money in your own pocket for the entire year, you’re already behind! Here are some savvy ways to catch up.
Ways to invest your tax refund
One of the biggest reasons why people rack up bad debt is because they don’t take the time to build up an adequate emergency fund to begin with. As a CFP® professional, I recommend having 3 to 6 months' worth of expenses saved to cover you in the event of the unexpected (job loss, major home/vehicle repair, injury, etc). If you’re married and both have steady jobs, you can probably get away with 3 months. If you’re single, or married with only one spouse working, aim for 6 months' worth.
But don’t just let that money sit in your savings account doing nothing! Remember, inflation eats away at those dollars over time and reduces your purchasing power. Instead, look into investing it in low-risk, low return vehicles like a money market fund, short-term Treasuries (aka T-Bills), or even certificates of deposit (CDs) at your local bank. Just make sure you stick to the shorter term options (1, 3, and 6 months) in case you need to access that money to pay for an emergency.
A Roth IRA is an Individual Retirement Account that you fund with money that has already been taxed. Since you’ve already paid tax on that moolah, it’s allowed to grow tax-free and can be withdrawn at retirement tax-free as well. That means you won’t owe Uncle Sam another dime on the dollars you contribute, nor on the investment earnings your account generates. Over years or even decades (depending on your current age), this could result in significant tax savings.
You can also use a Roth IRA to hold and invest your emergency fund. Money you contribute can be withdrawn at any time without tax or penalty, but earnings on those contributions shouldn't be touched until the account has been open for five years and you're at least 59 ½ years old. Otherwise those earnings may be subject to taxes and/or penalties.
A Roth IRA is really easy to establish. I’ll do a review on the process and provider I chose soon. In the meantime, look into the income limits for Roth IRAs to see if you qualify for one, and check out this video to learn more about traditional versus Roth treatment in both IRAs and qualified retirement plans like 401(k)s and 403(b)s.
If you’re already contributing enough for retirement, you could also invest your tax refund in a brokerage aka “taxable” account. Here, you can invest in a whole host of investment options from index funds to individual stocks. (*Whichever investments you choose, make sure to do your research as investing is not without risk.)
While taxable accounts don’t benefit from the same tax-free or tax-deferred advantages as retirement accounts, they can still be used to generate healthy investment earnings. And, if you hold your investments long enough (over a year), you’ll get preferential long-term capital gains treatment on any growth.
For most, long-term gains are taxed at just 15%, while people in the lowest tax brackets (10% and 15%) pay 0% on long-term investment gains. That’s right - if your taxable income is less than ~$38,000 as a single person or ~$76,000 married filing jointly (including your investment gains), you may not have to pay any tax on long-term investment earnings. To put it bluntly, you may be able to turn your money into more money FO' FREE (minus the risk of investing, of course). Consult a tax professional to learn how you can take advantage of long-term capital gains rates.
Here’s a fun one that isn’t mentioned often - muni bonds! When a state or local government/agency needs to raise money to fund a project (like a new highway, school, airport, etc), they often turn to the public for fundraising. If you, the investor, want to loan them money to finance a project, you’ll buy the municipal bond that corresponds to that particular mission. In return, the government/agency promises to pay you interest on the money you lend them and to give you your original investment back after a specified number of years.
The major advantage to muni bonds is that they are federal tax free, so you won’t owe Uncle Sam money on the interest you earn. Many can also be what’s called “triple tax free”, which means you won’t pay state or local taxes on them either if you’re a resident of that state and city. Major tax savings.
However, as with all investments, there are a couple of downsides to be aware of. Because you don’t pay tax on them and because they’re considered less risky bonds than others, the interest rate you earn is a bit lower than what you might be able to earn elsewhere. Municipalities are also subject to default risk, meaning there is some (slight) chance that the agency might not be able to pay interest or return your full investment as originally promised. As always, do your research. And if interested, talk to a bank or financial planner/advisor in your area to learn how to go about investing your tax refund in muni bonds.
Make extra mortgage payments
Use your tax refund to pay off your house faster! When you make your regular mortgage payment every month, the bulk of it goes toward two major things: a little bit toward the actual cost of your house, and a lot (at least in the beginning) to the mortgage lender/bank as interest on your loan.
When you make extra payments, however, you can elect to treat them as principal payments only. This means that every cent of your extra payment reduces your loan balance, rather than some of it going to the bank as interest. Paying down your principal helps you build equity in your home at a faster rate, thereby shaving years off of your mortgage obligation AND saving you a lot of money in interest in the process. Big win-win.
Does your kitchen or bathroom need a serious facelift? Have you been wanting to build an addition to increase the size of your living space? If so, dedicating part or all of your tax refund to home renovations may be a good idea.
However, I only recommend this strategy if, and only if, the potential increase in your home’s value exceeds the cost of the renovation itself. For example, if it costs $5,000 to renovate your kitchen, but a new kitchen would increase your home’s sale value by $7,000, then that’s likely a good investment. Conversely, if you spend $2,000 renovating a bathroom, but the new tile, vanity, and shower have no impact on your home's value, then that would be an inefficient use of your refund.
Too often, homeowners spend buckets of money on style changes or renovations that don't actually increase the potential price tag of their home. Consult a realtor in your area about your home’s current value and how it may change as a result of various upgrades.
Invest in your child’s future! Contribute some or all of your refund to a college savings account like a 529 plan. Accounts like these are great investment vehicles because your money grows tax-free over the years, and the earnings are untaxed when used to pay for qualifying education expenses.
Last, but certainly not least, use a portion of your refund to invest in yourself. Are there classes or certification programs you can complete to increase your salary or propel you into a new career? Have you always wanted to take music or language lessons that will increase your skill set? What about an intro to investing course online that teaches you how to put your money to work?*wink*
I’m clearly a huge fan of investing in the traditional sense, but I'm also a firm believer in the value-add that comes from investing in yourself. As they say, “You can't take it with you”. What you can take with you, though, and what people will remember about you, is how much you contributed to the world while you were here. So use your refund to invest in yourself and make the world a better place in the process.