No one loves doing their taxes, but many of us are rewarded with a refund at the end of it. You probably already have some idea of what you’d like to spend that money on. But spending it isn’t always the best decision. Here are some alternative ways to use your tax refund that you may want to consider.
1. Stash it in an emergency fund
Everyone should have an emergency fund containing at least three months of living expenses. Six months of savings is even better if you can manage it. An emergency fund can help you avoid debt if an unexpected expense arises, like an ER visit or losing your job.
If you don’t already have one, your tax refund can get you started. Stash this in a high-yield savings account where you’ll have easy access to it. Then, add to it a little at a time until you’ve reached your savings goal. Be sure to replenish your emergency fund after using it, so you’re prepared for next time.
2. Pay off high-interest debt
High-interest credit card debt can quickly spiral out of control, so it’s important to pay it off as soon as possible. If you’re lucky, your tax refund can knock out your debt completely. But if your debt is more than your refund, you’ll have to prioritize.
Focus on the card with the highest interest rate first. Pay this off in full, if possible. Then, put any remaining dollars you have toward your card with the next-highest interest rate, and so on.
3. Invest it in a retirement account
If you don’t have any pressing financial concerns, you can stash your tax refund in a retirement account. An IRA is probably the easiest option for most people. You can choose whether you want a traditional IRA, which gives you a tax break today, or a Roth IRA, which offers tax-free withdrawals in retirement.
This might not be the best option for you if you might need the money in the near future. The government charges a 10% early withdrawal penalty if you take funds out of your retirement account before 59 1/2. There are a few exceptions to this penalty, like large withdrawals for medical or educational expenses. You’re probably better off just keeping your savings out of a retirement account if this is a possibility.
The best-case scenario is leaving your money alone until you’re ready to retire. This way, it’ll have years or even decades to grow before you need to use it. A $2,000 refund invested this year could be worth over $20,000 in 30 years, assuming an 8% average annual rate of return. That could go a long way toward helping you cover your costs in retirement.
4. Invest in a health savings account (HSA) if you can
If a retirement account doesn’t seem like the right place to invest your money, a health savings account (HSA) might be a better fit. The money you stash here also reduces your taxable income for the year, and if you invest it, it’ll grow just like money in your retirement account. There are some restrictions on when you can access your funds, but you get tax-free medical withdrawals at any age, so you could still dip into your HSA in an emergency if need be.
Individuals with a health insurance plan that has a deductible of $1,400 or more can contribute up to $3,650 to an HSA in 2022. Families with a health insurance plan that has a deductible of $2,800 or more may contribute up to $7,300. Adults 55 and older can tack an extra $1,000 onto these limits.
If you don’t already have an HSA, you can open one with most banks or brokers. Whenever possible, find a provider that will enable you to invest your savings.
Spending your tax refund is still an option if none of the four suggestions above appeal to you. But it’s a good idea to weigh the short- and long-term benefits of each choice before you make the final call.
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