Rethinking That Tax Refund

Judith Ward, CFP®, Senior Financial Planner

Executive Summary

Receiving a tax refund is exciting, but what if taxpayers had more money in their pockets throughout the year instead? The following article poses real-world situations and practical advice for handling tax refunds. This information can be useful in discussing money management topics with clients or when discussing the benefits of financial wellness programs with plan sponsors.

If you received a tax refund last year, you definitely weren’t the only one. An estimated 74% of people received a tax refund in 2017—averaging close to $3,000—according to the Internal Revenue Service.

Many folks mistakenly view this windfall as “found money” when it’s really your money. Instead of having the dollars in your wallet, the money has been an interest-free loan to the government.

While you may look forward to getting a lump sum of your hard-earned money once a year, consider what you could do with an extra $250 a month if that money was included in your paychecks instead. You could pay off debt, save more for retirement, or have a little breathing room in your checking account.

Whether earmarking your tax refund for something specific or adjusting the withholding on your Form W-4 to take home more throughout the year, consider tackling your past, present, and future finances.

Past: Pay Down Credit Card Debt

Are your credit cards still suffering from a holiday hangover? According to our recent Parents, Kids & Money survey, one-third of parents let their credit card balances from holiday shopping linger for four months or longer. This is in line with the broader 2015 National Financial Capability Study that found 32% of consumers only pay the minimum due on their credit card bills. While credit cards may seem like a blessing because they’re so darn convenient, they’re also a curse because they’re so darn convenient. Ideally, you want to be able to pay this high-interest rate debt off each month and not carry a balance. 

Present: Set Aside Emergency Savings

Without fail, you will experience an emergency or unexpected expense that will require immediate funds. AAA reports that one in three people can’t pay a $500–$600 car repair bill without taking on debt. Home maintenance or repairs could set you back several thousand dollars. Setting aside funds to cover these kinds of unanticipated situations allows you to be prepared without having to raid your retirement savings or pay with a high-interest credit card. Once you have a couple thousand dollars on the side, you’ll want to build that up over time so you can cover three to six months of expenses in case of a job loss.

Future: Invest In You

What if some of that "extra" money went toward your savings goals?

If you’re in your 20s, get a head start on retirement savings. By saving $250 per month for 45 years, you would have almost $900,000. Even $100 a month can make a difference, resulting in over $350,000 at age 67. Make it automatic by setting up systematic contributions to an IRA or taking advantage of your workplace retirement savings plan.

This chart is for illustrative purposes only and is not meant to represent the performance of any specific investment option. Final account balances rounded to the nearest thousand. Assumes $250 and $100 invested each month in a tax-deferred account and a 7% annual rate of return.

Or if you have a newborn or young child, that $250 a month could buy almost four years of tuition when he or she is ready to go off to college. It could cover almost two years of total costs, including room and board. Open a 529 college savings account to get started.

For illustrative purposes only and not meant to represent the performance of any specific investment option. College savings assumes $250 invested each month in a tax-deferred account and 6% annual rate of return compounded monthly. College costs are based on College Board Trends in College Pricing, 2017­–2018 average costs for four-year public institutions increased each year by a 5% inflation rate. All figures are rounded to the nearest thousand.

It feels great to get a cash windfall. But when it’s money that you’ve already earned, why not put it to work throughout the year and reward your past, present, and future selves?

A 529 college savings plan’s disclosure document includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. You should review the 529 plan offered by your home state or your beneficiary’s home state and consider, before investing, any state tax or other state benefits, such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s 529 plan.

IRAs and retirement accounts should be considered long-term investments. Both IRAs and retirement accounts generally have expenses and account fees, which may impact the value of the account. Maximum IRA contributions are subject to eligibility requirements. Early withdrawals are subject to taxes and possible penalties. For more detailed information about taxes, consult a tax attorney or accountant for advice.

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