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?
Comments
Great points in your post! Taxes can be so confusing for many. My son and his wife both work in the medical profession, with each working at two facilities. When he found out that they were going to have to pay taxes this year, he was dumbfounded. How could this happen? They have a mortgage, a child, and only claim one deduction each? What they failed to recognize was that they were being taxed on the income received at each of the four jobs, and when these incomes were combined, it put them in a higher tax bracket. For many working second jobs, this can be a big factor, and one to consider when calculating how many deductions to take.
What did I do with my refund this year? It helped to make the final payment on my mortgage!
Congrats on being done with your mortgage! That’s huge!
Woo hoo! I love tax returns! This is one area where I disagree with 99.99% of folks. I absolutely hate the saying that you’re giving the money an interest free loan. If you’re money is in the bank you’re giving the bank a free loan to re-loan your money and make money, at least the Gov can use that money in the short run to increase cashflow for projects, but that’s beside the point. My biggest problem with this statement, is that it gives people a false sense that they are really going to invest their money and allow it to grow when the probability is very high that they will easily spend the extra $50 without pro-actively saving it. By hiding it from yourself you significantly increase your chances of building up a bigger chunk of saving which you can then invest all at once into something or make a big dent to your debt like you are doing.
Secondly I don’t agree with your math up above which is how most people calculate the potential money growth opportunity. In reality you are only getting $50 more every pay check not $1,200 right up front at the beginning of the year so you really have to calculate out the money growth on each individual $50’s per paycheck i.e. $50 x (0.0075/26 x 26) + $50 x (0.0075/26 x 25) + $50 x (0.0075/26 x 24) … etc. That comes out to about $5.06 in growth and on a 14% return that’s only about $94.50.
The question I ask myself is, how much does the likelihood increase that I’ll spend that extra $50 every two weeks at least once or twice throughout the year rather than save it. I reckon it’s a high probability for most people.
Oops! meant giving the government an interest free loan.
Thanks for catching the math error, EQ! One small formula error, and whoops, magical money appears! Haha.
You have a good point on the savings – I’d definitely set up auto-deposits into savings on investments for the extra $100 every month. If the money stays in my checking, I spend it.
Jane–Congrats on putting that tax refund to kill that debt. Oh man, glad I saw Epic’s comment because I thought I was the only one who claims 0 to get a fat refund. The whole thing about giving the government an interest-free loan never really resonated with me from a big win/psychological point of view. Agree that most people aren’t disciplined enough to actually put the extra paycheck amounts to work.
I’m happier receiving the fat refund once than the smaller bonuses in my paycheck.
A fabulous idea! Slamming windfalls like tax refunds onto debt is a fantastic idea. 🙂 Unfortunately we owed Uncle Sam $900 this year, so no refunds for us. Boo. But it did show us how powerful it is to have cash on hand for unexpected expenses like these. I’m grateful we’ve made all the changes we’ve made. 🙂
Good for you for putting the refund towards your student loan. That is a major expense to get paid off.
Thanks, Dave!
I’m so close to the finish line at this point that I just want to throw every spare penny at it just so that it’ll be finished faster. I’m on track to finish late summer, but I think I might be able to pull if off earlier…
My tax return is going straight into my tiny house fund! This was the first year I was able to use my built up tuition credits to maximize my return, so my return was big (5k). I know that’s never going to happen again so I’m not wasting my chance to use it wisely. For future years, I love your idea of changing the amount that gets withheld from your paycheque- I’ve never thought about it that way before!
What a huge return! To Epic Quiver’s point above, having a big windfall once a year can be a huge benefit to hitting certain financial goals… like a tiny house! Hopefully that gives a a significant boost towards your goal!