The Best and Worst Ways to Spend Your Tax Refund
Life + Money

The Best and Worst Ways to Spend Your Tax Refund

Iva Hruzikova/The Fiscal Times

Getting a tax refund can feel like winning a small lottery. And it’s tempting to blow the windfall. But hold tight: There are smarter ways to use your mad money than putting a down payment on a Harley or jetting to Aruba for the weekend, and they will put you a step closer to financial security.

Last year the IRS issued more than 77 million tax refunds averaging about $2,800, the agency said. That’s not pocket change. For many people, that’s bigger than a paycheck. So think before you splurge.

“Have a plan for the funds before they arrive and implement the plan as soon as you receive your check,” says Michael Busch, president of Vogel Financial Advisors in Dallas. “It’s dangerous to let the money sit in your checking account—it might get spent.”

Here’s are some do’s and don’ts from financial experts.

1. Fund your golden years. Use the refund to beef up your IRA or Roth IRA, says James Guarino, tax partner at Moody, Famiglietti & Andronico in Wakefield, Massachusetts. This only works as long as you have enough earned income for the year to meet contribution requirements.

Related: 10 Important Tax Dates for 2016

Or consider increasing your contributions to your 401(k), says Busch. You can’t deposit the refund directly into the 401(k), but you can increase the amount that is taken from your paycheck for the rest of the year. The refund will offset your reduced take-home pay. It’s a double win, too. “Not only will you get the refund into your 401(k) account this way, but you will also lower your tax bill because the increased 401(k) salary deferrals will reduce your taxable wages,” Busch says.

2. Put a dent in your debt. Eliminate that credit card balance once and for all with your tax refund. If you don’t have enough money to cover all of your outstanding balances, start with the one that has the highest interest rate and move down the rate ladder, says Chris Hardy, CEO at Paramount Investment Advisors in Suwanee, Georgia. In certain cases, interest you pay on student loan debt can be deducted from your taxable income (for the following year) up to $2,500, Hardy notes.

3. Save for a rainy day. If you don’t have an emergency fund or have a very small one, use the tax refund to increase your peace of mind. The rule of thumb is to be able to cover at least three months to six months of expenses. Keep it in a savings account or other account that can be accessed quickly.

“You never know when you need cash and since you have a nice inflow, now is a good place to start,” says Neil Waxman, managing director Capital Advisors in Shaker Heights, Ohio.

Related: Filing Alert: How Obamacare Affects Your 2015 Taxes

4. Pay down your mortgage. Use your refund to make an extra principal payment on your mortgage, Busch recommends. “A $1,000 extra principal payment at the beginning of a 30-year, $100,000 mortgage at 6 percent will save you nearly $5,000,” he says. “If your interest rate is higher, the savings will be even greater.”

5. Fund a child’s education. A tax refund is a great opportunity to start or increase your child’s or grandchild’s college savings fund, says Busch. You can use the refund to open a Coverdell IRA or a 529 college savings plan. If used for education expenses, the earnings on these funds grow tax-free.

“And the return on this kind of investment—a college education for your children—can’t be measured,” says Busch. “It’s priceless.”

6. Give it away. Pass along your good fortune by donating your tax refund to your favorite charity. This is also a smart tax move, because you get an extra income tax deduction for the following year.

7. Invest it. Make that tax refund work hard for you by investing the money in a non-retirement brokerage account. Then, watch that tax refund grow over time, increasing your overall net worth. “If you put away $2,700 a year for 10 years at a modest 5 percent return, you will have over $32,416,” says Vickie Adams, a certified financial planner in San Pedro, California.

Related: The 8 Most Common Tax Mistakes That Can Cost You Hundreds

8. Buy something. Even financial planners think its O.K. to indulge in guilty pleasures every now and again. “I've never been one to tell a client what they shouldn't do with their money,” says Taylor Schulte, president of Define Financial in San Diego. “It's important to maintain balance in their lives, and if they think that making a material purchase or taking a family vacation is what would be best, I can respect that.”

Here’s a good way to figure out how to spend it smartly, according to Waxman. Write down all the things you want to save for and prioritize them by importance. These can be short term, like buying new clothes or furniture; medium term, such as a big vacation or down payment on a house; or long term, like retirement or college savings. “Save or spend according to that list, but try and at least fund all of them,” Waxman says.

Niv Persaud, managing director of Transition Planning and Guidance in Atlanta, recommends doing a little of everything above. “Follow the philosophy spend-save-share,” she says. For example, take 10 percent—that’s $280 of the average refund—and spend it on something frivolous. Save 80 percent or put that money toward a financial goal such as buying a new home, preparing for retirement or college or paying down debt. Give the remaining 10 percent to your favorite charity.

But don’t…

Experts also offered some of the ways you shouldn’t use your tax refund. Don’t spend indiscriminately without a plan, says Waxman. “Consumption isn’t bad as long as it’s measured and done after thinking about the alternatives,” he says. He also says to avoid investing in your buddy’s stock tip.

Don’t purchase high-cost mutual funds or expensive insurance products, says Hardy.

“Do not spend it without having agreement in your family,” says Angela Giboney, owner of AFG Financial in Mill Creek, Washington. “Do not use it as a down payment on a car.”

Last, don’t get a refund next year, says Bryan Lee, founder of Strategic Financial Planning in Plano, Texas. “Rather than giving Uncle Sam an interest-free loan throughout the year,” he says, “they should change their withholding and use that money to invest throughout the year.”