With tax day right around the corner, you may be wondering how best to use your tax refund. The average refund, according to the latest IRS data, comes in at $2,873—a good chunk of money that could help you make some real headway on your financial goals.
So what’s the best way to really optimize your refund? Let’s unpack the details. Here are five ways to help your tax refund pack the biggest punch and put you on the most solid financial ground.
1. Chip Away at Your Debt
High-interest debt is a serious wealth killer, especially if you’re carrying balances from month to month on multiple credit cards. The Federal Reserve reports that the average credit card APR these days hovers at about 16.9 percent. What’s more, the average debt for balance-carrying households in the U.S. is a whopping $9,333, according to recent ValuePenguin research.
Thanks to numbers like these, simply making your minimum payment every month isn’t likely to make a significant dent in your total balances. The good news is that cash windfalls, like tax refunds, can be a game changer that dramatically reduces your debt in one fell swoop. The perks are twofold: Getting debt-free faster and saving money on interest in the long run.
Not sure which debt to prioritize? From a numbers-and-cents perspective, it’ll serve you best to chip away at whichever balances have the highest interest rates since they’re the most expensive to keep around. With that being said, some consumers prefer to knock out their debt in the order of smallest balance to largest, regardless of the interest rate (a.k.a. the snowball method). At the end of the day, select the strategy that will keep you motivated to continue chugging along on your debt journey.
2. Supercharge Your Emergency Fund
Think of your emergency fund as your financial safety net should disaster strike. If you were blindsided by an unexpected medical bill, car repair, or stretch of unemployment, could your savings account see you through? If not, you’re not alone. Forty percent of adults would be unable to cover a $400 pop-up expense without borrowing money or selling something, the Federal Reserve Board reports.
Having a solid emergency savings is the foundation of financial health. It empowers you to make your way through life’s financial hiccups without tapping your retirement fund, or worse, digging yourself into debt. Most financial planners recommend socking away three to six months’ worth of living expenses. If that’s too lofty, or you’re paying off high-interest debt, aim to maintain a rainy day fund of $1,000. That should provide a reliable cushion in the face of a small financial emergency.
3. Funnel Your Tax Refund into the Stock Market
If you’ve got your debt under control and your savings account is in good shape, consider investing your tax refund. Translation: Make this money work for you. It may be tempting to simply park your refund in a high-yield savings account, but the best return you can hope for here is only about 3 percent, according to Bankrate. The stock market tells a different story.
While ups and downs are par for the course, the average annual return is about 7 percent, after accounting for inflation. Thanks to the power of compound interest, time is hands down your greatest asset. If you begin putting $1,200 annually into a Roth IRA at age 30, you’ll likely have close to $177,500 by the time you’re 65. Your tax refund could help you get ahead of the game without impacting your regular monthly budget. Look to tax-advantaged retirement accounts to get you going. Bulking up your 401(k) is an especially wise move if your employer will match any portion of your contributions. (Hello, free money!)
4. Make Headway on a Big Financial Goal
Retirement probably isn’t the only long-term financial goal on your radar. Whether it’s saving for a down payment on a home or beefing up your travel fund, we all have competing money goals. Your tax refund can be a powerful tool for moving the needle on a big-ticket savings target.
The question to ask yourself is how soon you think you’ll need the money. If you’re saving for, say, your kids’ college fund, you may still be years away from cashing in. In this case, consider investing your tax refund in a regular brokerage account. They’re super flexible, and you can hopefully grow your money a little more along the way. If you have a shorter horizon, parking the money in a high-yield savings account is the best way to go.
5. Pump Up Your Passive Income
Why not use your tax refund to lay the groundwork for a consistent stream of incoming cash? Passive income is exactly what it sounds like—income that requires little to no effort to generate. Leveraging rewards credit cards to your advantage is a great example. Some passive income streams, however, require some capital to get rolling.
Real estate, like investing in a rental property, is one of the first things that comes to mind. Your tax refund could boost your savings enough to get your foot in the door. Of course, you have to have some appetite for risk, and the whole thing depends on finding a property that’ll actually generate a return. In other words, it requires a lot of research on the front end. Managing the property is also a big responsibility if you plan on doing it yourself.
If real estate isn’t your thing, you could also use your tax refund to spruce up a room in your home before renting it out on a platform like Airbnb. Into crafting? Utilize your tax money to buy inventory for a new Etsy shop. The idea is to land on something that interests you so that it doesn’t really feel like work. From there, lay the foundation to earn additional income over the long haul. Your tax refund could very well be the thing that gets a new business up and running.
There isn’t one right or wrong way to use your tax refund. Instead, it’s about taking stock of your current financial situation, then using this cash windfall in a way that makes the most sense for you.