Most financial gurus argue that the best tax refund is the one that’s $0, as long as there’s no need to make a payment. However, this is not the most common number that most people will see. The average refund for Americans for the 2015 tax year was $3,210. Needless to say, this is a nice chunk of change.
Many Americans will choose to spend this money on frivolities that bring no lasting financial value. They might put it toward a down payment on a new car or truck. They might decide to renovate a room. These expenses are not likely to build wealth, but there are ways to use a tax refund to build wealth.
A Tax Refund Can Go Toward An Emergency Fund
One of the first steps that personal finance professionals will recommend is that every household set up an emergency fund. They usually urge readers or listeners to start off with $1,000 in an emergency fund. From there, after all debt outside of a home mortgage gets paid off, the emergency fund should build to between three and six months of expenses.
Obviously, $3,120 is not going to meet three to six months of expenses for most people. For those who are fairly frugal and who live outside of some of the more expensive locales, this amount could reach at least one month. If you still have debt, however, the first step to take with your tax refund is to set up a $1,000 emergency fund and put the rest toward the debt.
This $1,000 will improve your net worth. It will also allow you to avoid going into debt if your radiator busts or you need new tires. This is huge. It can remove some of the stress that can come with being a slight emergency from being completely broke.
A Tax Refund Can Pay Off Debt
If you’ve already set up a $1,000 emergency fund, you’re in pretty good shape. There will be no need for you to take on debt if you have an unexpected expense. This can bring you to the second option for building wealth with a tax refund. Rather than buying a new 60-inch flat-screen 3D TV, you can put your new windfall toward any outstanding debt you have.
If you have credit card debt at a high interest rate, the tax refund should go toward it. Even if you have to set up the $1,000 emergency fund first, you’ll still have $2,120 left if you get the national average back. This could go toward debt and save interest costs that will give you more of your income to spend and save going forward. If you have no consumer loans outstanding, the refund can pay off a few months of a student loan or a mortgage early.
Invest Your Tax Refund
If you’re fortunate enough to find yourself with no debt and a fully funded emergency fund, your tax refund should then go to work making more money for you. Perhaps you have a couple of kids and your refund is closer to $5,000. You could almost fund an IRA for a year.
If you choose to invest in a Traditional IRA, you’d also see your taxes for the next year cut. The IRS does not ask whether you’ve invested in the IRA with your tax refund. By making a contribution on just the average refund, you’d see a tax cut of at least $312. This is based upon a 10 percent marginal rate on the average tax return. Those who have a rate of 15 percent would see a tax cut of $468 because investments in a Traditional IRA are treated on a tax-deferred basis.
In addition to seeing a tax refund, you’d also see some dividend income start to grow should you decide to put the money to work in stock. You could choose to buy individual dividend-paying stocks, or you could opt for an index fund that tracks the S&P 500, dividend payers, or even the entire US or international markets. The dividend that your companies or funds pay you could then get reinvested to buy even more dividends, which would build passive income even more quickly.
A lower tax bill can only help the next year’s return. Investing in this way can only help you see a growing benefit to using your tax refund for something other than a new car or a cruise. Once you’ve built up a nice net worth, these purchases will take only a small percentage of it. For those who have debts, these purchases will only keep them in debt.
A tax refund is the biggest windfall that most Americans will see in a year. This sudden infusion of money can provide the temptation to go on a spending spree. Rather than buying things that will do nothing to build your wealth, why not use them to build an emergency fund, pay off debt, or invest in stocks or bonds. These steps can help you sleep a bit better at night, and they can definitely help you build up your net worth.