Millions of Americans filed their taxes by April 15, and many have begun receiving their refunds from the Internal Revenue Service (IRS), as well as the states they live in. As of April 19, the average federal tax refund this year was $2,725 — a sizable chunk of change.
If you’re expecting a tax refund, don’t stow it in your checking account, or else a few months from now, you’ll be wondering where it went. Instead, come up with a better plan — to put that money to good use however it will best serve your needs. That might mean deploying it to pay off high-interest debt, investing it, using it to finance home or car repairs, or putting it toward starting a business.
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Here are 20 suggestions for how you can use your tax refund this year, and why you should consider changing your withholding so that you have a smaller refund next year.
1. Pay off high-interest debts
If you’re carrying any high-interest-rate debt, including big credit card balances, your first priority should be to pay that off. A tax refund can help a lot if you apply the chunk of change to your balance.
An interest rate between 18% and 25% is not uncommon for credit cards. If you’re carrying $20,000 in debt, those rates would cost you around $3,600 or $5,000 annually in interest alone. Using a $3,000 refund to pay off debt that charges you 18% is like earning an 18% return — a difficult feat to achieve in the stock market.
2. Save in an emergency fund
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Do you have an emergency fund? This is a savings account worth three to nine months of living expenses. Having this safety net protects you when the unforeseen happens, such as a job loss or a costly medical expense. If you don’t have a robust emergency fund, consider deploying your tax refund in this way. A 2015 report from the Pew Charitable Trusts found that fully 60% of American households “experienced a financial shock” over the previous year, with nearly a third experiencing two shocks.
3. Make a prepayment against your mortgage
While high-interest-rate debt is the most problematic debt, it’s worth considering your low-interest-rate debt, too, such as your mortgage. Most home loans permit prepayments that will reduce the principal owed to the lender, and doing so shortens the life of your loan, saving you a lot in interest expense.
Here’s an example: If you’ve borrowed $200,000 at 4.5% in a 30-year fixed-rate mortgage, your monthly payments are close to $1,000. If you make an extra payment of $3,000 near the beginning of the 30 years, you can shave about 11 months off the life of the loan and avoid paying more than $8,000 in interest. Apply several tax refunds to your mortgage and it may help you enter retirement mortgage-free!
4. Contribute to an individual retirement account (IRA)
In 2019, you can contribute up to $6,000 to one or more traditional or Roth IRA(s) — in total — and if you’re 50 or older, the limit is $7,000. While that’s probably more than your tax refund, it can still go a long way toward helping you max out your annual IRA contribution. Socking away $3,000 in an IRA for 25 years will compound to become more than $20,000 if it averages annual growth of 8%. Combined with income from Social Security, that could make up your income for nearly an entire year in retirement.
With a traditional IRA, a $3,000 contribution will reduce your taxable income by $3,000. If you have taxable income of $70,000, and you contribute $3,000 to a traditional IRA, your taxable income shrinks to $67,000 for the year, meaning you avoid paying $720 if you’re in the 24% tax bracket. Money in the IRA can be invested and will grow on a tax-deferred basis, and your withdrawals will be taxed in retirement.
With a Roth IRA, a $3,000 contribution has no effect on your taxes in the contribution year. Taxable income of $70,000 remains just that, despite a contribution to a Roth IRA. But follow the rules, and you’ll be able to withdraw all your contributions and earnings tax-free! If your Roth IRA swells to $250,000 over 20 years, that can all be tax-free income in retirement. (A 24% tax hit on that nest egg would have cost you $60,000.)
5. Contribute to a health savings account (HSA)
Another good thing to do with your tax refund is contribute to an HSA, which is a triple-tax advantaged account available only to folks who are covered under a high-deductible health plan (HDHP).
You fund an HSA with pre-tax money, thereby lowering your tax bill (much like a contribution to a traditional IRA). That money can be used tax-free for qualifying healthcare expenses, such as doctor visits, lab work, and eye exams. The money in the account can accumulate over many years, invested and growing. Here’s a nifty feature of HSAs: Once you turn 65, you can withdraw money from your HSA for any purpose, paying ordinary income tax rates on withdrawals. That makes it a combination health savings account and retirement savings account!
The HSA contribution limit for 2019 is $3,500 for individuals and $7,000 for families. Those 55 or older can chip in an additional $1,000. You must have a qualifying HDHP insurance plan in order to be eligible to take advantage of HSAs.
6. Contribute to your child’s 529 plan
If you have children who hope to attend college, consider socking your tax refund in a 529 plan. You can save and accumulate a lot of money with a 529 plan. Money in these accounts grows tax-free, and withdrawals that pay for qualified education expenses are not taxed, either. On top of that, many states offer additional tax breaks for their residents who contribute to the state 529 plan — and some states even offer tax breaks for money saved in another state’s plan.
529 plans sport generous contribution limits of up to several hundred thousand dollars per beneficiary — and you don’t have to use your state’s 529 plan, so read up on plans from many states and choose which will serve you best.
You might also consider the Coverdell Education Savings Account. It offers a wider range of investments for your money, but it only accepts up to $2,000 per year in contributions.
7. Buy a life insurance policy
If anyone, such as a spouse, a child, or even your parent, is depending on your current or future income, you’d better be carrying life insurance. If you don’t have a policy, it would be smart to put your tax refund toward one. Term policies are generally better deals than whole life ones, as they only have you paying for coverage while you need it.
And if you are paying for life insurance now and no one depends on your income anymore — perhaps because your kids are grown and your spouse would be financially secure even without your income — then consider ending your policy to save money.
8. Invest in your health
However big (or small) your tax refund is, you can probably put it, or part of it, toward improving your health. Depending on your interests and abilities, you could buy some weights, a used bicycle, or a new pair of running shoes. If the refund is big enough, you might pony up the money for a home treadmill or elliptical machine, a personal training package, a gym membership, or fitness classes.
It could also cover an annual membership in a local community sponsored agriculture (CSA) program. A season’s worth of fresh vegetables can cost anywhere from around $100 to several hundred dollars, depending on how much you’ll be getting.
9. Take classes to further your career
Another way to deploy your tax refund by investing in yourself is to tend to your career development. This could be as simple as freshening your professional wardrobe with a trip to the mall or consignment shop, or it could involve taking some courses and earning a new professional certification or designation.
Alternatively, you might learn a new language, coding, or another skill to help you land a better-paying job or snag a promotion at your current workplace.
10. Improve your home
You could spend your tax refund on home improvements that will save you money or get you some of your money back when you sell your home.
Remodeling a kitchen or bathroom could mean getting a chunk of that money back upon the eventual sale of the home. Some improvements, such as a deck, a new front door, or a new garage door, could recoup nearly their entire cost. Investing in some professional landscaping might add as much as 10% to 15% in perceived value to your home.
11. Invest in alternative energy for your home
Some alternative-energy investments can pay off over many years, like installing solar panels, which can generate so much power some people can even sell excess power back to an electric company. Programmable thermostats can help you use less energy.
Other planet-saving investment possibilities include replacing various home appliances with Energy Star-certified ones, which are environmentally friendly. Their efficiency should save you money on your energy bill.
“More than 2,200 product models from more than 140 manufacturers were recognized as ‘ENERGY STAR Most Efficient’ in 2017. By choosing ENERGY STAR, a typical household can save about $575 on their energy bills and still enjoy the quality and performance they expect,” according to the folks at EnergyStar.gov.
12. Pay for required auto maintenance
Has your car been making some funny sounds? If there are some needed repairs or maintenance that your vehicle needs, it can be smart to spend your tax refund on them now. Otherwise, you might have to pay for it at a time when you have less cash on you — and it might cost more, if the problem has gotten worse. For example, if you ignore a failing radiator, your car might overheat, causing enough damage to necessitate a new engine.
13. Fund needed home maintenance
Similarly, you might spend that tax refund on home maintenance. If your roof is old and worn, you could use your refund to pay for some or all of a new roof — which is likely to cost between $5,000 and $15,000, depending on the materials used and the roof itself. Installing a new water heater can set you back around $1,000 or more, while having the outside of your home painted can cost between $2,000 and $6,000.
14. Invest in a certificate of deposit (CD)
Here’s another good idea for that tax refund: If you think you might need to use it in a few years, put it in a short-term savings vehicle that offers a competitive interest rate. Here are some recent averages:
Those are rather paltry numbers, but you can probably do better than average by digging around online and checking with your local financial services companies and the banks you do business with. There’s a good chance you can find rates close to 3% — far from the return offered by stocks, but it’s still a smart place to park short-term cash.
15. Invest in stocks
If you don’t have to use that tax refund money for five or 10 years, consider parking it in stocks. Overall, the stock market has averaged annual returns of close to 10% over many decades (though it can average significantly more or less over shorter periods), and it’s hard to beat that.
Here’s how much you could amass with a single $3,000 investment over various time periods if it grows at 8%, on average, annually:
A simple way to invest in the stock market is to buy one or more low-fee, broad-market index funds. The SPDR S&P 500 ETF (NYSEMKT: SPY) distributes your money across the 500 companies in the S&P 500, which make up about 80% of the U.S. market.
16. Invest in bonds
If your portfolio is full of stocks, with no exposure to bonds, you might want to add some bonds for diversification’s sake, especially if you’re nearing retirement. Bonds are essentially loans, where you’re lending money to a party that promises to return your principal — plus interest. The safest ones (from the U.S. government) tend to pay modest interest rates, especially in low-interest-rate environments, while corporate and municipal bonds offer higher rates and risky “junk” bonds offer the highest rates. You should avoid junk bonds.
Ways to invest in bonds include buying individual bonds and holding them to maturity, in which case you can expect to receive their stated interest rate, and buying into bond mutual funds. One retirement strategy is to buy a variety of bonds that will mature at different times, generating income over many years.
17. Start a specific-goal-oriented savings account
You might also park your tax refund in a special savings account that’s earmarked for a specific goal, such as a home theater, a new car, or a luxurious vacation. Having different savings accounts dedicated to specific goals can help you better keep track of your progress toward them and prevent you from spending that money on other things.
You might set up lots of separate accounts at your bank, or you might just have one savings account for all those dollars, keeping track of how much is allocated toward each goal in a notebook.
18. Start a small business
This idea for your tax refund is a big one, but it could be a powerful one for you: Start a business.
The U.S. Small Business Administration suggests that micro-businesses, especially many home-based ones, can cost as little as around $3,000 to launch. These might include a handyman service, a lawn care business, tutoring, or a pet-care sideline. Alternatively, your refund can be part of a bigger investment. A food truck business costs between $28,000 and $114,000 to start, while some franchises cost less than $10,000 to start. Common business expenses include equipment rentals (or purchases), location rent, marketing costs, website services, inventory, business insurance, tax preparation fees, editing, coaching, blogging, and consulting.
19. Splurge on a treat
If you’re in good financial shape, with well-funded emergency savings, no high-interest debt, and your retirement accounts on track to provide sufficient income in your future years, you can afford to be less productive with a tax refund by treating yourself instead. You might spring for a flat-screen TV or a faraway vacation. But don’t discount the value of simply adding that money to your retirement savings, as you may end up needing more to sustain yourself in retirement than you expected. Better safe than sorry, but if you’re really, really safe already, splurging on something that would improve your quality of life is not out of the question.
20. Give it away
A final excellent idea for your tax refund is this: Give it away.
Sure, it makes sense if you’re in great financial shape, but it can also be a reasonable option if you’re still improving your finances, because billions of people are living in far less comfortable conditions. Millions of Americans are living below the poverty line, while many more are struggling with even less in other countries. A $1,000 or $3,000 charitable donation could go a long way to helping those less fortunate than yourself.
On Heifer.org, you can give water buffalos to needy families to help them lift themselves out of hunger and poverty. Through FeedingAmerica.org, you can provide thousands of meals to hungry people. Through Ashoka.org, you can support a social entrepreneur working to tackle a big issue (such as human rights, the environment, hunger, poverty, education, crime, or health) in an innovative way. Even better, charitable donations can result in welcome tax deductions.
Aim for a smaller refund next year
As you think about how to spend your tax refund, remember that ideally, most people shouldn’t have much of a tax refund to spend. After all, that money is essentially money you have loaned the U.S. government for free — it’s your own money that you haven’t had possession of for many months.
Modest refunds are common and not a problem, but big refunds generally happen when we have too much withheld from our paychecks. You can adjust your withholding by submitting another W-4 form to your employer. On the other hand, if you have trouble saving money for various financial needs, receiving a big lump-sum payment every year that you can deploy productively isn’t the worst thing.
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Selena Maranjian has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
