A lot of us get tax refunds in the spring every year. For a lot of us also, that can be a really large windfall of money. Whenever you get a windfall of money you really want to make sure that you use it responsibly. So what would I do with a tax refund? Let me show you.
Do You Anticipate Owing Taxes Next Year?
This is the first thing that you should do with a big tax refund check. If you are in an unusual situation where you anticipate owing a lot of taxes next year, just save the money that way you won’t have to scramble next year to pay your taxes.
The reason this is at the top of the list is because tax debt is THE MOST DANGEROUS DEBT there is. The interest rates can be high, the penalties can be high, and the IRS has basically unlimited power.
If you don’t pay your taxes, you can be fined, have your wages garnished, or even put in prison. Make sure you avoid any chance of not paying your taxes and facing the consequences.
If you anticipate owing taxes next year, either pay them in advance or put them into a high yield savings account and let the money sit there until next year.
With all that being said, most people will not find themselves in that boat. If you don’t anticipate owing a lot of taxes next year, here are the steps you should take when you ask what to do with a tax refund.
First: Save the Money
I know this is the most boring answer that you could think of, but this might be the most important.
If you don’t currently have a 3-6 month emergency fund, you need one. It’s not a matter of if, but a matter of when an emergency happens to you and you need to be prepared.
A tax refund check is a great way to get ready for an emergency.
If you are not sure if you need a 3 or 6 month emergency fund, here is an article where I explain how to choose the size emergency fund you need.
If you have an adequate emergency fund, then you can skip this step. Or if you use part of your tax refund to finish off your emergency fund, then move to the next step!
Second: Repay Family Debt
This is a little bit of a hot take, I know. Paying off family members is not something that most people put at the top of the list. After all, most family members (and close friends) who have loaned you money usually don’t charge interest.
So why should you pay off 0% interest debt first? Because you don’t want your relationship to change or be altered because of money.
When people who are close owe each other money it can get weird and awkward in the event that you are not able to pay on time.
I have seen it happen dozens of times in my career. And I’ve even been in that boat myself.
If you have debt to family members or close friends, just pay it off. It will take a lot of stress off of your plate and make you sleep better at night.
Third: Pay High Interest Debt
If you owe money on high interest debt it is a real killer to your financial life. If you owe money on credit cards, it doesn’t matter how much money you are investing and what interest those investments are earning, you will still fall behind.
What should I do with a tax refund?
If you have high interest debt, pay them off with your tax refund.
And to be clear, “high interest” is not always the same for everyone. But for nearly all people, any loan (other than a mortgage) that is >7% should be considered “high interest”.
Fourth: Put it into Retirement Accounts
After you have saved an emergency fund, paid off family and close friends, and paid off high interest debt you should move into putting that money into your retirement accounts.
This is really important if you feel like you are behind on saving for retirement.
This can come in a number of ways.
If you have a 401k, 403b, Simple IRA, etc. through your job you can bump up your withholding from your paycheck for a pay cycle or two to equal the amount from your tax refund check that you want to go into your retirement account.
But an easier way to do it is to simply open up a Roth IRA or a traditional IRA and put the money in there.
Either way (or a combination) works. But if you feel like you are behind on retirement savings, a tax refund is a really good way to start getting caught up.
Fifth: Pay Off Low Interest Debt
After you have done all of the items before, now you can start paying off low interest debt. This would generally be debt of <7%.
The reason that you save low interest debt to the end is because low interest debt hurts your financial life the least.
High interest debt really stings. Not having an emergency fund can be really dangerous. And not paying family members money that they lent you can make Thanksgiving dinner a little weird.
But once you have all of those items done, then feel free to move on to low interest debt.
Final Thoughts
What should I do with a tax refund?
Be responsible with it, yes. But also make sure to have a little fun with it.
Go out to a nice dinner. Take a mini vacation. Buy the new household item you’ve been wanting. Just make sure to be responsible with the purchase you make with a tax refund (or any money for that matter).
You can do this!
I am here for you!
Until next time!
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