As tax season rolls around each year, it’s usually either a time you dread or a reason to celebrate. If you’re getting a tax refund, it can be tough to decide how to spend your money. But using at least part of your refund to save or invest can help you feel more secure now and better prepared for the future.
Below, you’ll find a quick explanation of what a tax refund is, when it typically arrives and smart reasons to invest your refund instead of spending it all at once.
What is a tax refund?
A tax refund may feel like you’re getting “free” money, but it’s actually money that the Internal Revenue Service (IRS) has held for you. The typical scenario goes like this: when you receive a paycheck, your employer withholds a certain amount of money in taxes to send to the IRS. At the end of the year, you look at the money that was sent to the IRS and compare it to the amount you owed the IRS. After deductions, your tax refund is the overpayment of your taxes that the government owes you. In essence, you’re essentially getting your own money back instead of the “bonus” it feels like you’re receiving. If you’re wondering how much you’ll get, several sites offer free tax calculators to help you estimate your potential IRS refund. Just remember, it’s an estimate, and not an actual tax preparation software or a tool. You can also consult an accountant or tax advisor if you want more accurate figures.
When do tax returns come?
By law, employers must send you any employer and payroll-related tax forms by January 31st of every year. If you haven’t received these documents by then, contact your employer immediately. You can file your taxes as soon as you have all of your tax documents.
Refund timing depends on how you file your taxes and how you choose to receive your money. If you e-file, the IRS notes it typically takes about three weeks to receive a refund. If you mail a paper return, it can take six weeks or longer after the IRS receives it. Choosing direct deposit is often the fastest option, and the IRS reports it issues over 90% of refunds in less than 21 days.
You can also track your refund status using IRS tools like “Where’s My Refund?”.
What should you do with your tax refund?
Before you decide, take a moment to think about what would help you most:
- Would you feel better with emergency savings?
- Do you have high-interest debt that’s hard to pay down?
- Are you saving for a near-future goal like a car or home?
- Do you want to boost retirement savings?
If you’re not sure, a simple approach is to split your refund. For example, you might put some toward savings or debt and set aside a smaller portion for something fun.
Reasons to invest your tax refund
If you invest your tax refund, you’re using it to support your future goals instead of creating new bills.
1. Build – or boost – your emergency fund
Unexpected costs happen – car repairs, medical bills or a sudden job change. That’s why it’s critical to set aside money for an emergency. Yet nearly half of Americans have the means for “emergency savings” which has long been considered a basic wealth-building goal. Even a small cushion can make a difference, and you can keep building it over time.
2. Discover the concept of compounding investment earnings.
Compounding investment earnings is the idea that your money can grow over time when earnings generate additional earnings. When you choose to save or invest your tax refund, you have the potential to make money on the interest in your account that accrues over time. It’s also a smart move to consult with a qualified financial planner beforehand who can help you invest wisely and track your progress.
3. Invest your tax refund to meet short- and long-term goals.
Investing your refund can help you reach both your short and long-term goals. For example, saving your tax refund enables you to save up for that new car you’ve always wanted or go on a trip you’ve been dreaming about. While this may feel like you’re simply splurging on a big-ticket purchase, you’re actually working toward a goal and reducing the need to take out a huge loan or put it on a credit card, which just creates more debt. Or you could work toward a long-term goal, such as buying a home. Saving your tax refund each year can help you increase the down payment you make on a home, which could mean a smaller monthly payment. To help plan for how much you might receive, a tax refund estimator can help you determine how much you should expect from your IRS refund.
4. Strengthen your retirement savings
For many of us, retirement feels so far away. Yet saving for your retirement is one of the best ways to use your tax refund. Even if you’re in your 20s or 30s, putting away a consistent monthly amount in tax deferred investments like an employer-sponsored 401(k) savings plan now means the money you’ve invested will have the potential to earn compound interest over the years, all making a larger nest egg for retirement.
Your tax refund can help give your retirement savings a boost if you haven’t started investing in a plan yet or want to increase the money you’ve set aside for your golden years. And it’s always a good idea to get a head start on planning for your future financial, medical and legal needs.
5. Enjoy peace of mind.
A sense of security is probably the number one reason to invest your refund instead of spending it. Knowing that you’ve taken the money you’ve earned and have set it aside, whether for emergency funds, buying a home or retirement, can give you the added confidence that comes from making a solid, wise financial decision, as well as the peace of mind that you or your family will be better protected in the future.
Different Ways to Save Your Refund
Once you’ve decided why you want to invest your tax refund, you’ll need some tools to help put your dreams into action. The following five investment vehicles are some of the most common ways people save their tax refunds:
Contribute to your IRA.
Putting money into an Individual Retirement Account, or IRA, is a great way to use your refund, especially if your employer doesn’t offer a retirement savings contributions vehicle. The goal is to save around 10 percent to 15 percent of your salary for retirement. Depositing all your tax refund into your IRA every year is a solid, consistent way to help you meet your long-term retirement goals.
Pay down high-interest debt
Many credit cards issuers charge users around 24% interest for unpaid monthly balances. If you don’t pay off your interest every month, you end up paying interest on your interest. Use your tax refund to start bringing those numbers down every month by using your refund to make a dent in your credit card balance.
Save for education
Open up a 529 college savings plan to start saving for your kids’ college education. It’s a great way to save on a consistent basis, and these plans allow you to deduct the amount of money in your account from your tax return that you file to the state every year.
Consider additional protection with insurance.
Your insurance plans should include not just health, home or renter insurance. You should also consider legal insurance should you ever need an attorney for a situation like estate planning needs, fighting a traffic ticket or a dispute with a home contractor. You can also consider other types of insurance coverages that can help pay your bills if you are too sick or unable to work.
Saving your tax refund every year isn’t always necessary, but consider the positive side to the investment. You’ll probably end up spending the money at some point, but you should let the money work for you for as long as you can.