Your Tax Refund - Spend or Save?
By: Lisa Mikhael CFP
Ah tax season - the time of year we approach with apprehension as we face the task of completing our tax returns. We are hoping for a negative balance, which signifies that the government owes us money rather than the other way around. To our delight, an amount appears on line 484 and we smirk with satisfaction - plans already in the works of how we will spend that refund. But before you go on an all out shopping spree in your mind, let's take a look at how you can make the best use of that refund. "What?" you say. "And be practical with this windfall of money I've been given?" Well, the first thing to keep in mind is that this isn't free money. You were simply giving it to the government for safekeeping in exchange for a whopping 0% rate of interest. I suppose one could view it as forced savings from which you plan to go on that well deserved vacation; however, if you have been following a well-developed financial plan, you probably have that goal mapped out and are setting aside funds in an account with a much higher interest rate. So let's get back to the task of considering how you can best allocate your refund to get the most value out of your money.
First and foremost, your refund dollars will work hardest for you in paying down high interest debt. If you have credit card debt, you are likely paying somewhere around 19% on any outstanding balances. In this case, your refund is earning 19% for you since it is eliminating a part or all of the balance that otherwise would have incurred this high interest charge. If your refund is enough to substantially reduce or even eliminate your credit card debt, take this opportunity to get caught up on your payments and make a commitment going forward to pay off your credit card balance in full each month.
After credit card debt, the next best place to allocate your refund dollars is on other mid to high interest debts such as unsecured lines of credit or personal loans. As with credit card debt, if your refund can partially or fully eliminate your outstanding balance, it will have earned you the respective rate of interest currently charged on that account.
Another good use of your tax refund is to establish an emergency fund. The rule of thumb here is to save the equivalent of three months' salary in a high interest savings account for emergencies or in case you are unable to work for an extended period of time due to sickness or injury. Use your refund to jump-start your liquidity fund and make a commitment to set aside a nominal amount to it on a regular basis. Chances are you won't even miss the funds and will greatly appreciate them in time of need.
Should you put your refund towards the pre-payment privileges allowed on most mortgages? Well, that depends. Unless you have eliminated all other debt and are on track to reaching all your financial goals, paying down your mortgage is not necessarily the best use of your refund dollars. The reason for this is that your mortgage is considered good debt since it is invested in an asset that appreciates in value. Also, your mortgage interest rate is likely very low; your refund would only be saving you 4-5% on any balance it pays down. Your refund will work much harder for you in your retirement plan, particularly if you are a balanced to aggressive investor where rates of return of 6-8% or more can be expected over the long term in a well diversified portfolio, not to mention the compounding effect that those funds will have over time.
Now that we've explored all the practical ways in which you can allocate your tax refund, keep in mind that we need to have some fun in life too. Therefore, a balance between being sensible with your tax refund and rewarding yourself in some way is not only realistic but will serve to re-energize you, allowing you to forge ahead with your financial goals with renewed vigour.
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