It’s April, which means tax returns are due! I had to file taxes in three different states for 2016, which ended up being quite a pain. That said, I got roughly $1,000 in tax refunds, which is incredibly exciting! I’m excited mostly because it was almost going to be just $300 before I realized that I was double-taxing myself in two out of the three states I filed in.
Why is it so important to plan around a tax refund? For many, it’s the biggest windfall we’re going to get all year. A few years ago, I read an article that stated that millennials treated their tax refunds as savings that they wouldn’t have been able to build up otherwise, which quite bothered me. I wish I could find that source article! Now, I’m glad to see that recent surveys are more optimistic. Will you be one of the 39% of millennials that plans to use their refund towards savings or debt repayment?
Me? I’m putting my tax refund straight towards the student debt I still have left, which will be roughly 5K after this month, huzzah! This means I’m on track with my savings goals to be finished with my debt by late summer.
I like to think of tax refunds as a good way to jumpstart a debt snowball repayment method. Instead of allocating your refund across different needs, consider just throwing it all in one place. If you have a budget and can stick to it, then chances are you can operate just fine without the refund going towards spending. Whether it’s paying off a small loan, taking a chunk out of a larger one, or investing it, that tax refund is best used for what future you will appreciate, not present you.
And now, let’s pivot
The average tax refund is around $3K. I’ve always had refunds around $1K, and my goal is to cut that down as close to $0 as possible (without owing money). Why? Because when you get a refund, you’ve essentially given the U.S. Government an interest-free loan. That’s money that is better served working for you. So, while this post is focused on refund allocation in name, I also want to address refund removal. If you’re getting huge sums as a tax refund, it’s worth going back to your employer and adjusting your W-4. Chances are, you’ve set an incorrect number of allowances. That’s worth fixing asap because it means you’ll see a little more money in every paycheck that you get. I would rather have an extra $50 twice a month than $1,200 back in my account in April.
Let’s continue with this example. Thanks to the power of compounding interest, let’s see just how much of a difference $50 a paycheck over the course of a year.
Example 1: You put the $50 into a high-yield savings account that offers a 0.75% interest rate. $100 a month x 12 months = a final account balance of $1,205. That’s a 1% increase over the interest-free return of $1,200. Not much, but enough for a coffee or two servings of a home-cooked meal!
Example 2: You put the $50 into an investment account that (wouldn’t this be nice) averages 1% growth every month. $100 a month x 12 months = $1,268. That’s 6% higher than the tax return alternative. (This is essentially what I’m currently doing with my personal investment account, and my return to-date is ~6%.)
The dollar difference ($5 in example 1 and $68 in example 2) is small because the time period is short. However, you’re going to file many more tax returns in the future, and all that money can start working for you today. Use that refund to your advantage while you can, but consider making the ultimate goal not having a refund at all.
What are you doing with your tax refund this year?