Not everyone gets one, but it’s always a welcome sight — a tax refund. If you receive a refund this year, how can you best put it to work?
The answer depends, to a large extent, on the size of your refund. In 2012, the average tax refund was about $3,000, according to the IRS. Let’s look at a few possibilities for how you might use this amount:
Help fund your IRA — In 2013, you can now put in up to $5,500 per year (up from $5,000 in 2012) to a traditional or Roth IRA. And if you’re 50 or older, you can put in an additional $1,000 per year above the new contribution limit. Consequently, your $3,000 refund could cover more than half of your maximum IRA contributions, or slightly less than half if you’re 50 or older. And if you don’t think that $3,000 would make much of a difference, consider this: If you invested the $3,000 in an IRA that earned a hypothetical 7 percent annual return, and you never put in another dime, you’d end up with nearly $23,000 after 30 years. And if you put in that same $3,000 per year to your IRA — well below the maximum — every year for 30 years, earning that same 7 percent annual return, you’d accumulate more than $303,000. (Keep in mind that you’d eventually be taxed on your traditional IRA earnings; Roth IRA earnings grow tax-free, provided you meet certain conditions.)
Pay off some debts — In the last few years, Americans have done a pretty good job of lowering their individual debt loads, according to the Federal Reserve. But if you still have some outstanding loans or a credit card balance that carries a high interest rate, you might want to consider applying your tax refund to these debts. The lower your monthly debt payments, the better your cash flow — and the more money you’ll have available to invest for your future.
Help build an emergency fund — Life is full of unexpected events. If you need to purchase a new furnace or pay for an expensive car repair or incur a hospital bill, will you have the money available? If you don’t, you might be forced to dip into your IRA or other investments. This move could result in taxes and fees; more importantly, it will reduce the financial resources you’re counting on to help meet your long-term goals. You can help avoid this problem by building an emergency fund containing six to 12 months’ worth of living expenses, kept in a liquid, low-risk account. Your tax refund could give you a nice start to this fund.
Invest in a 529 plan — If you have children (or grandchildren) whom you’d like to send to college, you may want to invest in a 529 plan. Your earnings grow tax-free, provided withdrawals are used for qualified higher education expenses. (Withdrawals for other purposes will result in taxes and possible penalties.) Contribution limits are quite high, so you can put in significant amounts each year — including a $3,000 tax refund.
As you can see, you’ve got some attractive options for using your tax refund — so consider them carefully. If you can apply more resources to your various financial goals, you may find yourself in a better position in the future.