Every year, millions of Americans receive a tax refund. This year, you may have been one of them. While in theory it’s best to prepay your taxes accurately with no anticipated refund—after all, a refund means you have overpaid your taxes during the year, effectively giving the federal government an interest-free loan—many enjoy receiving a refund, as it may feel like an unexpected windfall.
Previously, we explored what NOT to do with your tax refund. Now, let’s explore what you SHOULD do with it instead.
Build up an emergency fund. An emergency fund consists of savings you can tap into for unexpected expenses, like an illness or job loss. As many people unfortunately learned in the last year, an emergency fund is vital to good financial management. If you don’t have one currently, a good initial milestone to set is $1,000. Then, think about your living expenses in a given month, and try to set a goal for between one and six months’ worth of expenses. A good rule of thumb is: the less predictable and stable your income and expenses are, the more you should put toward your emergency fund.
Pay down debt. Whether it’s credit card debt, college loans, or your mortgage, it’s always a good idea to reduce your debt. If you are able to pay down debt, you can reduce the amount you pay in interest charges, leaving you with smaller payments overall. The higher the interest rate, the more you save by paying it off sooner.
Save for retirement. The earlier you start saving for retirement, the more time you have to build up your retirement savings. You might even be able to deduct some of the contributions on next year’s return as well. If your employer offers matching benefits through a plan like a 401(k) or SIMPLE IRA, be sure to take advantage of it.
Buy life or long-term care insurance. While no one enjoys thinking about what would happen if you became incapacitated or passed away, purchasing life and/or long-term care (LTC) insurance that fits your needs and budget may help to protect you and your loved ones. Also, you may have heard that the Washington State Long Term Care Trust Act is instituting a compulsory short-term care benefit, funded via a 0.58% payroll tax, but LTC insurance policyowners may opt out of this tax permanently if they purchase LTC insurance prior to the effective date of this law, July 24, 2021. Learn more here.
Make a charitable donation. If you itemize your deductions when you file, you may be able to deduct the amount of your donation. Even if you decide against this option, this time of year may inspire you to do some “spring cleaning” and donate unused items instead.
It’s important to put your tax refund toward smart financial goals. You worked hard for your refund so make sure it works hard for you too.