Tax season is one of the most dreaded times of the year but one thing that could makes things much better, is a nice tax refund.
Millions of us each year get a pretty good chunk of change back from the IRS, but what should we do with all that cash once we have it? Here are three things you can do to make the most out of what might be the most you'll get at one time all year long.
The first thing you can do with that tax refund is get a jump start on that emergency fund. I think if you ask most people, they would say that they want to do a better job of saving, but, as life typically does, it can get in the way. But a tax refund is a really good place to kind of jump start and get that emergency fund started for the first time. Now, I know, this sounds really boring. No one is really excited about starting a savings account but I think the pandemic has shown us just how important it is to have a strong emergency fund in place. Now, the typical rule of thumb for an emergency fund is you want to set aside six to twelve months of your mandatory expenses. These are the expenses that you'll have to pay each and every month, regardless of what's going on. Your rent or mortgage, your insurance, food, utilities, these things have to happen regardless of what you have going on. You want to set aside six months of this because it allows you to cover big, unexpected hits to your income, things like a loss of a job or a big expense that you didn't see coming. And the IRS makes it really easy to split your refund into direct deposit and you can split it into up to three bank accounts. So make sure you do that, and set aside a portion of that refund into a savings account to get that emergency fund started.
Thing number two that you can do with your tax refund, attack your debt. With debt, your worst enemy is really going to be the interest that they charge you and every dollar that you pay towards your debt is one less dollar that's sitting there recurring interest. And your tax refund can be a huge help in putting a nice dent in that debt, especially on that high interest debt on things like credit cards and with credit cards, interest rates can easily exceed 20 percent. And what makes this really dangerous, is that this interest compounds and that means they charge you interest on the interest they charge you the previous month, so you can see how this can really build and grow out of control.
So for example, if your interest rate is 20 percent on your credit card, every $100 of debt means that over the course of a year, you recue $20 in interest. If you have a $1,000 in debt, this would mean more than $200 in interest each year. So as you can see, putting a good portion of your tax refund towards debts can be one of the most impactful things that you can do with your tax refund.
Last but not least, the last thing you can do with your tax refund is start or at least get ahead on investing. You can use your refund to open up an IRA or at the very least increase your contributions toward your 401K plan. Investing can be one of those things that can feel intimidating and scary at times, but it really is one of the best tools that we have available to reach that goal of retiring. And using a portion of your refund to open an IRA, which is an individual retirement account, it can be the moment that you can choose to go from being just a savor to being an investor. So, if you receive a refund this year, make sure your use it to take on one of these three areas.
Starting an emergency fund, getting that foundation in place, paying down debt, especially high interest debt, or becoming an investor for the first time. Because no matter which on of these things that you choose, you'll be putting yourself in a much, much better place financially.