What Smart People Do With Their Tax Returns
One of the few great things about tax time is the day your refund arrives. Sure, filing your tax return was a pain, but nothing raises spirits quite like seeing a deposit in your checking account. While visions of a new Céline bag or Eames chair may be dancing through your head, the most fiscally responsible people (i.e. those of you with a retirement account; those of you who don’t spend $300 on shoes) know to spend their refunds wisely.
Considering the average return in 2016 is $3053, now is a great time to take stock of your finances. We spoke to a panel of experts to find out the best ways to make your money work for you. No, a shopping spree at West Elm isn’t on their list of advisable financial decisions, but you might be surprised by some of their tips.
Close your cart and keep reading—this is how smart people spend their tax refunds.
The key to maximizing your money starts with one simple step: budgeting. Emily Holbrook, director of the millennial market at Northwestern Mutual, says the first mistake people make is treating their tax return like a gift, rather than hard-earned money.
“While it’s tempting to want to blow your refund on a shopping spree or big-ticket item, you also need to be aware of how that money could have even larger benefits in the future,” she says. “If you’re smart, you’ll be able to maximize the funds and do more with the money you get back. Even a small amount can go a long way when saved or invested early.”
Not sure how to designate funds to different areas of your budget? Try the handy 50/15/5 rule.
“Fifty percent should go toward essential expenses like outstanding rent or debt, 15% should go toward retirement, and 5% should go toward short-term savings, like a backup fund,” explains Wendy Liebowitz, vice president at Fidelity Investments.
As for the remaining 30%? That’s up to you. Leave some money aside to spend on something you enjoy, like a weekend away or dinner with friends.
DRAFT A BUDGET:
You might think that paying off debt should be your number one priority, but author and host of Money Girl podcast Laura Adams says saving for a rainy day is just as important.
“Building your emergency fund should be a top priority—even before paying down debt,” she says. Create an account that’s separate to your everyday one, so you’re deterred from making withdrawals. Then be realistic about the amount of money you’d be comfortable depositing. You don’t have to put aside the whole amount, but the end goal of an emergency fund is to have the equivalent of about four months’ salary.
Yes, chipping away at credit card debt or paying off a student loan is important, but Liebowitz says it’s not necessarily the smartest way to spend your refund.
“Ask yourself this: If you didn’t pay off this debt, could you invest the money to earn more than your debt's interest rate? If the answer is no, then pay off that debt,” she says. At the top of your priority list should be high-interest debt, like credit cards that charge 18% in interest or more.
One common misconception is that student loans should be paid off ASAP. “If you have student loan debt, take a close look at those interest rates. Government-subsidized loans may have low interest, but private loans are usually higher,” she explains. Higher rates = pay it down. But if your student loan debt is consolidated at a lower rate than your target investments, perhaps invest the money instead.
Retirement might seem a long way off, but financially savvy people know that small contributions now can have big gains, thanks to compounding interest. If you’ve paid off your debt and have an emergency fund in place, congratulations! Next step: building a nest egg so that you can enjoy retirement.
According to Adams, you’ve got two main choices: Increase your 401(k) contributions, or create a Roth IRA.
“Contributions to a workplace retirement account like a 401(k) must be deducted from your paycheck, so you could increase your payroll contribution and use your tax money to pay for any shortfalls in your budget,” she suggests. If you’re not contributing already, Liebowitz says that’s a must. “Don’t leave this free money on the table!”
Going back to option two, opening a Roth IRA is a smart option for tax-free growth. In essence, the money you contribute to that account and its gains can eventually be withdrawn without being charged a tax. If you’re able to make a Roth IRA contribution and plan on not withdrawing money until retirement, it’s a smart way to grow your money, tax-free. Just make sure you're able to live without it—the penalty for dipping into it early will cost you.
If you’re planning of having children, starting to save now is a prudent move. A 529 college plan is a great way to invest your tax return. Put simply, money contributed to this fund is exempt from federal income tax when used to pay for education expenses like tuition or books. Holbrook says it’s a savvy way to put money aside for the future.
“If you’re interested in a 529 plan, I recommend you begin saving toward it as early as possible. Even if you’re only able to invest a small amount to start, the compound growth on the savings adds up over time,” she says.
Investing money can be daunting, so it’s important to chat with a pro. “If you’ve done all of those things and still have dollars to invest, review tax efficient investments that can provide you the opportunity to grow your money without it being eroded in the future by taxes,” says Liebowitz.
“A financial consultant can help you evaluate individual securities, mutual funds and exchange-traded funds, as an example.”
If you’re nervous about investing in stocks, she suggests bonds are a conservative option. “If you want to invest in U.S. savings bonds, plan on holding the investment until the maturity date to receive the face value of the bond and collect the interest payment,” she says.
In essence, there are a ton of investment options, so if you’re interested in channeling your hard-earned tax refund into an investment, tee-up some time with a professional to find the best option for you.
Yes, you read that right. If you want to use your tax refund to treat yourself, research suggests it’s smarter to buy an experience rather than a possession.
A Harvard Business School study found that money can buy happiness, but not when it’s spent on material things. Researcher Michael Norton believes it’s because purchases like a new TV unit or phone usually leads to alone time while spending money on experiences encourages social interaction. The fleeting nature of travel also makes us savor the moment.
“Because experiences disappear, they let us make up a reality that was amazing and wonderful, and they make us happier,” he explains. In other words, after you’ve set money aside to pay off debt or build your retirement fund, you have total permission to spend your tax return on a well-earned vacation! Here are some ideas to get you started.