The Best Ways to Use Your Tax Refund – and the Worst
Life + Money

The Best Ways to Use Your Tax Refund – and the Worst

Flickr / Chris Potter

If you had an extra three thousand bucks in your pocket, how would you use it? It’s an important question for the three-quarters of Americans who are expecting a tax refund from Uncle Sam this year.

Last year, the average tax refund was $2,800, according to TurboTax, a nice chunk of change. But that windfall can quickly disappear if you don’t have plans for it.

Related: How to Get Your Taxes Done for Free

“If you keep in mind that your tax refund is your own earned money, and not a lottery gain, then this should help you want to get ahead, ease your financial difficulties, build a safety net, (or) get you closer to your retirement goals,” says Alina Parizianu, a certified financial planner at ACap Asset Management.

Here are six ways you should spend your tax refund to improve your financial security.

1. Pay down credit card debt. Interest rates on credit cards typically are variable, and right now they are on the rise, increasing your monthly payments, says Bob Gucer, a certified financial planner with Benedetti Gucer & Associates. So it makes sense to shrink these debts as quickly as possible. Put money toward the balances with the highest rates first and work your way down, he says.

2. Save for an emergency. Consider building your cash reserve or emergency fund. “I'd recommend three months of expenses readily available for dual-income earning families and six months for single-income earning families or single individuals,” says Gucer.

3. Invest in your retirement. Contribute your refund to your IRA or Roth IRA, but be mindful of annual limits ($5,500 or $6,500 for those 50 and over). Or, increase the amount withheld from each paycheck for 401(k) contributions and use the tax refund to make up for the shortfall, says Neil Waxman of Capital Advisors. Unfortunately, you can’t make lump-sum contributions to 401(k)s.

Related: 7 Common Tax Mistakes That Could Cost You Thousands

4. Invest in your home. There are a few ways to turn that tax refund into home equity. Consider what home improvements you may need and can save you money in the future like a new hot water heater, new windows or extra insulation, says Waxman. Or, consider a home renovation that increases the value of your home (for a list of the top 10 home improvement projects for your money, click here.) Finally, consider paying down your mortgage. Paying one extra mortgage payment a year can shave off years of interest payments on your home.

5. Invest in your kids. Put the tax refund into a 529 plan for your children’s future college costs.

6. Save with a purpose. Are you saving for a down-payment on a house or car? Or could this money help pay for that wedding next year? It’s fine if you eventually plan to spend your tax refund, but it’s better if the money is earmarked for a specific goal, rather than spending without thinking.

Related: 4 Ways to Get Your Tax Refund Faster

And that brings us to what you should avoid doing with that tax refund burning a hole in your wallet. “The first thing I've seen clients do with a tax refund is not having anything to show for it,” says Marguerita Cheng, CEO of Blue Ocean Wealth. “You don't want to blow it on something frivolous or just let it fritter away and evaporate in your checking account.”

Refrain from a shopping spree with your windfall, says Ellen R. Siegel, a certified financial planner in Miami. “At the very least, take 10 percent of it for being frivolous or indulgent, and put the rest to work wisely,” she says.

Avoid gambling or drinking your tax refund away, says Parizianu, while Waxman says “don’t make loans” with it. Last, if you’re already struggling with debt, don’t use the refund for a down-payment on something that creates even more debt, creating a downward spiral.