This article first appeared on February, 21 2016 and was updated February 19, 2020.
Tis the season! Depending on your situation, you probably either love tax time or you dread it like that horrible English report you had to read in front of the class in the 11th grade. The way you feel about tax season generally comes down to one important factor — Are you getting a tax refund?
If you expect to receive a refund from the IRS, tax time is exciting. You may already be thinking about all the fun ways you can spend the money. But I encourage you to take a step back. A tax refund isn’t free money, so you shouldn’t treat it that way. It’s money you already worked hard to earn and overpaid to the IRS.
I am in no way an accountant. Still, I’ve learned some tips over the years that might help you.
How Tax Refunds Work
Before we get into what you should do with your tax refund, it helps to understand how the tax system works. In the United States, taxes are pay-as-you-go. Your employer withholds your estimated taxes out of your earnings and sends the funds to the IRS throughout the year.
The amount your employer withholds from your paychecks is based on the number of dependents you claim on your W-4 form.
When you enter a higher number of dependents on your W-4, fewer taxes are withheld from your paychecks. Your take-home pay is higher, but the IRS receives less. When you enter fewer dependents on your W-4, your employer withholds more money out of each paycheck. Your take-home pay is lower, and the IRS receives more. People who claim zero exemptions often end up with a refund at the end of the year.
You’ll find out your final tax liability to the IRS the following year when you fill out your tax return. Your tax return helps you calculate the taxes you owe, minus deductions, and credits, minus the money you’ve already prepaid to the IRS out of your paychecks. If you paid too much throughout the year, a tax refund would be heading your way. If you paid too little, you will owe a tax bill and possibly a penalty.
You can file your refund on your own, or you can pay a tax professional to file your taxes for you. Personally, I like to use a licensed CPA to file my taxes. Even though I could do it myself, I don’t know all of the rules and regulations to get the best results possible.
Make a Plan
If your tax return shows that the IRS owes a refund, you’ll probably breathe a sigh of relief. (Owing money to the IRS can be stressful.) Everyone’s situation is different, but tax refunds often total several thousand dollars. In 2019, the average tax refund was over $2,800.
The best way to avoid wasting your refund on something you’ll regret is to make a plan. You need to figure out the best way to use this influx of money before the deposit hits your bank account. Otherwise, the money can slip through your fingers quickly, and you’ll kick yourself later.
Smart Ways to Use Your Tax Refund
Need some inspiration? Here are four smart ways you can spend your tax refund if you’re expecting one.
1. Pay down high-interest debt. If you have lingering debt, I suggest this is your first priority. Pay off those high-interest balances and wipe the slate clean, if you can. Not only will this move save you money on interest fees, but it might also improve your credit score.
Resource: Check your credit score for free with Credit Karma.
2. Contribute to Savings Goals. Your tax refund gives you the perfect opportunity to pad your savings account. It’s a great time to accomplish the six-month rule with your emergency fund. You can open at CIT Bank Savings Builder Account for just $100 a month to get a high interest rate.
Six months might seem like a lot. You might say to yourself, “There’s no way I can build up a full 6-month emergency fund. So, if I can’t save it all, why try?” But a little savings is better than no savings. Even if you only save a little, you might have enough to cover minor emergency setbacks, like needing a new tire or a new washer and dryer.
3. Invest in yourself. If you want to start a new business or advance in your career, investing in yourself can pay off. You might invest part of your refund in a new training course or certification. Perhaps you’ll launch a new website for your side hustle or attend a conference to connect with and learn from successful entrepreneurs. When you invest in yourself wisely, it could pay off for years to come.
4. Think about the future. A refund check can also give you a chance to put money away for retirement. Whether your tax refund is big enough to max out your Roth IRA or just put away a little more for retirement, every dollar helps. Even if you don’t have a lot to invest, compound interest can make up for that — believe me!
Do you have young children? Starting or growing a college savings fund, getting term life insurance, or start investing a little money with Acorns are great ways to spend your tax refund. Trust me, you’ll be glad you made this choice when your child calls to tell you the tuition bill amount for their first semester of college.
The Bottom Line
Remember, a tax refund isn’t free money. It’s money you already earned but didn’t get to spend throughout the year. Now, instead of incorporating those funds into your monthly budget plan, you get to choose how to spend a lump sum of your hard-earned money at once.
Did you feel like your refund was too large this year? Was it too small? Are you unhappy with the amount of tax money withheld from your paychecks? There are a lot of different opinions and feelings about this subject. Some people prefer to receive as much money as they can throughout the year and keep their refund close to $0. Personally, I think owing the IRS, and having a tax bill is stressful. I’d rather pay more money throughout the year to avoid that possibility as much as possible.
In the end, you have to choose the approach that’s right for you. If you need help figuring out the perfect number of dependents to claim or need answers to other personal tax questions, talk to a tax professional you trust for advice on your individual situation.