Let me start by saying that I don’t advocate getting a large income tax refund back. In fact, I suggest adjusting your payroll tax withholdings so that you’re making the most of your income throughout the year.  Getting a sizable income tax refund back every year essentially means that you are giving the government a free loan. And as you probably know, they will definitely not return the favor for you, so why give them free money. 

Another reason why I dislike large income tax refunds is that we often have the tendency to splurge or spend impulsively.   An income tax refund no different than any other windfall. Without a clear plan, having a pile of cash fall into your lap can quickly turn from a blessing to a curse. If you’re anticipating a tax refund, I have 5 suggestions to make sure that you’re getting the best bang for your buck. 

5 Smart Ways to Spend Your Tax Refund

1. Start a Roth IRA or an individual retirement arrangement.

A Roth IRA is a tax-advantaged retirement savings account that allows you to withdraw your savings tax-free.

If you’re unfamiliar with Roth IRAs, here are a few of the high points: 

  • Roth contributions are post-tax, meaning your contributions will not lower your tax bill today.
  • BUT, your contributions and the gains grow tax-free forever. (Pretty awesome, right?!)
  • There are no required minimum distributions (RMDs) with Roth IRAs in retirement, so it’s a great tool to pass down wealth to your kids and grandkids (if that’s a goal for you). 
  • Roth IRAs offer flexibility. You can make qualified withdrawals (tax and penalty-free before age 59.5) for reasons such as permanent disability, purchasing a home, or funding your children’s college education
  • You must have earned income in order to contribute to a Roth (if you have a stay-at-home spouse you can open a spousal Roth on their behalf). And if you have a teenager with a summer job, consider having them open a Roth.

Wouldn’t it have been awesome if you still had money from your 1st summer job accumulating compound interest?

2. Get ahead on monthly cash flow.

So let’s say for example, you spend $4,000 every month to run your household that includes your rent, car payment, minimum debt payments, and household spending (groceries, gas, personal care etc.) If you get a $5,000 income tax refund this year you could use the refund money to pay your current most bills while allowing your usual paychecks to accumulate in the bank untouched. The untouched paychecks will then be used to cover expenses for next month. Voila! You’re now one month ahead in cash flow and are officially no longer living paycheck to paycheck. 

3. Attack pay high-interest debt.

It can be tempting to spend tax refund money on tangible items like new clothes, shoes, and furniture. But, if you really want to become debt-free one day soon, it will be important to take advantage of windfall money for debt payoff acceleration.  If you have high-interest consumer debt such as credit cards or department store lines of credit, it makes sense to attack those first. Or you could opt to pay off the smallest debt, regardless of interest, to gain a quick win. 

4. Stack the emergency fund.

When you don’t have an emergency fund, any and everything can become an emergency. The first emergency fund goal that I recommend is to get to $1,000 in savings. The next goal is to have one month of core expenses saved up. The ultimate goal is to accumulate 3-6 months of core expenses. These funds will be set aside in a high-interest savings account just in case a job loss occurs or another major expense comes up unexpectedly. Having a solid emergency fund will help you avoid accumulating more debt. There’s no need to reach for a credit card if you have a safety net in place to cover unexpected events.  

5. Establish (or fill up existing) sinking funds.

A sinking fund is a short-term fund that can be used to save incrementally for an anticipated purchase or large expense. The balance will sink or decrease as you use the money for your purchase. Sinking funds will also help you avoid sinking your monthly budget. I have to frequently remind myself of this because I have a tendency to feel bad about depleting my sinking funds. But that is exactly the point! The money should be used for your anticipated purchase in order to avoid disrupting your monthly cash flow plan (budget), reaching into your emergency fund, or swiping the credit card.  Sinking funds are a great way to take the panic out of your purchases. 

I hope that you’re inspired to go out and make the most of your income tax refund. If you haven’t done so, take a few minutes to brainstorm how to best utilize your own refund!