Smart Things To Do With Your Tax Refund

Key Takeaways

• A snowball is paying off the lowest debt and rolling the payment into the next debt.
• If you don't have debt obligations, it might be wise to invest your refund.
• However, an emergency fund doesn't just have to sit there waiting for bad news.

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It's tempting to fantasize about what to do with a windfall—like your tax refund. Got a $2,000 tax refund coming? You could pay off the balance on that credit card, pay off your car, or buy the vacation to Bali you deserve, or start that emergency fund. Each of these very tempting options cost about $2,000, but what if you did something different?

There are ways to put that money to use that would continue to pay off in the future. Here are some of the top financially smart things to do with your tax refund.

Create an emergency fund

Setting money aside often seems like the least exciting thing you could do. On the other hand, if you don't have an emergency fund, when something goes awry with the car, or you have to make a trip to the emergency room, or you need to travel on a moment's notice for a sick relative, you will turn to a credit card which will immediately begin charging interest. Also, if for some reason you lose your job, you need money put aside to cover your living expenses while you look for another one.

However, an emergency fund doesn't just have to sit there waiting for bad news. You could put the money in a nice liquid account where it can grow but where you can also get to it if you need to, such as a credit union savings account, short term CD, or something like Acorns.

Throw a snowball at your debt

A snowball is paying off the lowest debt and rolling the payment into the next debt. Let's say you owe three debts:

Debt 1: $2,000 at 15% interest. You pay $124 a month.

Debt 2: $4,000 at 15% interest, you pay $240 a month.

Debt 3: $6,000 at 15% interest, you pay $300 a month.

You use your $2,000 tax refund to pay off the first debt. Now you still owe $10,000 on the other two debts, which could take years to pay off unless you make a snowball out of the payments.

Debt 1 is gone. So, add that $124 payment to the amount you pay on Debt 2. Now you're paying the same amount every month, but you're paying $364 a month toward debt 2 and will, therefore, pay it off in 12 months instead of the original19 months.

By the end of that year, the first two debts are gone! Debt 3 is now whittled down from $6,000 to $3,000. If you put the $664 you were paying toward all three debts toward that remaining debt, you'll be debt free in five months! Now you can start applying that money toward savings or a future goal.

...Or throw an avalanche at your debt

Where a snowball begins with the smallest debt, the avalanche begins with the largest interest rate. Say your three debts have three different interest rates:

Debt 1: $2,000 at 3% interest. You pay $124 a month.

Debt 2: $4,000 at 15% interest. You pay $240 a month.

Debt 3: $6,000 at 4.5% interest. You pay $300 a month.

The loan with the highest interest will take 19 months to pay off and cost more than $500 in interest. However, if you put the $2,000 tax refund toward this loan, it will only take nine months to pay off and cost a little over $100 in interest.

Next, take the amount you were paying toward that debt and begin to tackle the debt with the next largest interest rate. You can pay that off in 12 months and only pay, again, a little over $100 in interest. Again, when you get the debts paid off, you can begin to save that money you formerly used to pay the debts.

If you're in debt, it's probably smarter to get rid of the debt, and the painful interest, than to use the windfall to start saving for something else—because that debt is costing you money.

However, if you don't have debt obligations, it might be wise to invest your refund.

Invest the money

What does investing your tax refund mean? It could mean investing in stocks, bonds, mutual funds, or even cryptocurrencies — depending on how long you want to keep the money in the investment and how much risk you're willing to take with the money.

Investing could also be investing in courses that will advance your career and which are tax deductible. Alternatively, it could be investing in your kids' education. When you take the money out, there's no tax, if you use it for education. The only problem with these accounts is that it is taxed if not used for education. However, according to the new tax laws, it can be used for Kindergarten through 12th grade and is not required to be used only for higher education.

It could mean investing in your home, if you need repairs or can make a home improvement that will increase the value of your home. If it is the kind of repair that can earn you a tax break—such as installing solar or other energy-saving improvements—even better.

Get yourself a special treat

Some people, though, have their employers take out the maximum in taxes to ensure they'll have a pile of money when it comes to vacation time. It's a kind of forced savings plan. If that's the strategy you've been using, and you don't have debt that's costing you money month after month, enjoy Belize!

So, if you're looking for help to figure out the best way to manage your money to get into a healthy financial position as quickly as possible, contact us!