Spring is here, and the tax refunds are rolling in. Many Americans are already pricing their new TVs and tablets. But what if spending your tax refund isn’t the best idea? What if it would’ve been more profitable to not even get a tax refund? Here’s a quick look at some wise uses for that check from the IRS. And why you might not want to get that check in the first place.
Nobody likes being in debt. For some, the thought of buying that new TV with a refund check is ludicrous. They’d rather hurl it at their debt. If that’s you, you have an admirable goal. But blindly throwing your money at debt isn’t always the best idea. You need a plan. And part of that plan involves savings.
Many who begin the process of getting out of debt quickly are soon frustrated and give up. Why? Because some unexpected expense or emergency comes along and derails the whole process. That’s why it’s important to build an emergency fund before you begin to aggressively pay off debt. You can let that fund absorb your emergencies so you can stay on track with your efforts toward debt freedom.
So how much should you save? Financial expert Dave Ramsey recommends putting $1,000 in your bank account before you begin to pay off debt. This will be enough to cover most minor needs, such as an emergency car repair, so your income source isn’t interrupted.
According to the IRS, the average tax refund in 2019 was over $2,800. That should be plenty to get your emergency fund started.
But there’s another level of emergency funding that you should establish. Ramsey recommends saving the equivalent of 3 months of income, as well, should you lose your job or have a serious medical expense. That’s more than $1,000. But you don’t have to save that right away. Ramsey actually recommends paying off most of your debts first.
You can use your own discretion as to when you should implement level two. You may want to hold off on it while paying off smaller debts, like personal loans and credit card balances, while saving it before paying off large debts, like a new car you just purchased, especially if you have a lower interest rate. We recommend establishing the “level 2” emergency fund before you aggressively begin to pay off a house.
Once you’ve saved your emergency fund, start working on that debt. This will not only save you money on the interest you’ll pay if you don’t repay your debts early, but it’s also one of the fastest ways to improve your credit score. To keep with the Dave Ramsey method, you can use the “debt snowball,” which accelerates your debt repayment with each debt you pay off. It works like this:
-Order your debts from smallest to largest.
-Begin making minimum monthly payments on each of them except the smallest.
-Aggressively pay off the smallest loan first with your entire monthly surplus of income, which we’ll call value X.
-Once the smallest debt is paid, roll X into the minimum payment for the next largest debt. We’ll call that payment amount value Y. Your monthly budget won’t change, but your repayment will begin to accelerate.
-When debt #2 is gone, roll X+Y into the minimum payments for debt #3. Can you see the snowball begin to form?
-Repeat this process until you’re debt-free.
Perhaps you’ve already started the snowball, but your tax refund will go a long way toward knocking down one or more of your debts, rolling that snowball faster.
A Word About Savings
Once you have your emergency fund and your debts are paid off, you can begin to save for the long term. But there is an exception here. If you own a home, your mortgage is designed to be paid off in 15 to 30 years. While aggressively paying off your home is a smart goal that will help you build wealth, we don’t recommend you put all your savings goals on hold for decades while you pay off this much larger sum. Start a college fund, bolster your emergency fund, or prepare for the eventuality of replacing your car, making regular payments to these funds each month. You can set these as budget items while still accelerating your mortgage payments.
Use Your Tax Refund Monthly
A tax refund isn’t a stimulus check from the government. It’s not money that just comes from nowhere. In fact, it’s your money. You’re actually getting it back. The refund is just the difference between the tax you paid and your tax liability for the year. Basically, the government overcharges you on each paycheck to make sure you pay up in the event that you make more money than they expect you to. Then, when you don’t, they give you that money back. You overpay by default.
But you can actually control how much money the IRS initially takes out of each paycheck. When you file your annual W-4 with your employer, you can adjust your number of allowances to prevent that extra money from coming out of your paycheck in the first place.
Isn’t it better to be safe than sorry, though? You might see the standard overpayment as a bit of a cushion, insurance against owing the IRS big when tax time comes. And so it is. But all year long, when that money is in the hands of the IRS, it’s not accruing any interest. It’s just sitting there. You could be saving it, or using it to pay off your debts each month, rather than waiting for a big check in the spring.
For example, if you get that average $2,800 tax refund, and you get paid biweekly, that means there’s an extra $107.69 coming out of each paycheck. How much faster could you get that debt snowball rolling if you had an extra $215 each month to put toward repayment? If you’re already out of debt, you can save that $215 and put it into a high-yield savings account where it will gather interest. You won’t get a big check back in the spring, but you won’t mind.
What you do with your tax refund is up to you, but we recommend building a small emergency fund, getting out of debt, building a larger emergency fund, and saving for the future, in that order. If you’re looking for more financial advice and tips on how to best handle your tax refund in 2020, stay tuned to our Helix blog. Cheers to financial freedom.