If you filed your income taxes and were told that you were going to receive a tax return, congrats!
Actually, it’s not something to necessarily celebrate, as it’s a return of money that you overpaid towards your Federal and State Income Tax bills.
That being said, you have some capital headed your way outside of what you already earn from your profession and other sources of income. Now, you have to start thinking about what to do with those funds.
Your gut reaction is probably to spend it, as it’s likely not money you were counting on. Before you do so, however, you should give some careful consideration to other options on the table. What feels good and what’s best for you isn’t always the same thing. This is especially true when your personal finances are involved.
This article will provide you with some ideas as you anticipate how to spend your federal and state income tax returns.
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Set up an Emergency Savings Fund
A strong emergency savings fund is a crucial element of any financial plan, regardless of your income or net worth. If you don’t have one already, this is likely where your tax return needs to go.
An emergency fund is a savings account that holds at bare minimum 3-6 months’ worth of expenses. This type of account should not be held in the same light as an operational account, such as a standard checking account.
Why Emergency Savings?
Life happens. You never know when you’re going to get hit with an expense that will cost you a couple thousand dollars, such as:
- Car repairs
- Medical bills
- Home repairs
- Family emergencies
- Unexpected travel
As it relates to investing, emergency savings can play an important role as well. This is true even though the funds aren’t included in your investable net worth. The last thing you want to do is be forced to liquidate assets at an inopportune time.
The classic example of this would be selling investments to provide you with enough liquidity to survive a recession. This causes you to lock in steep losses that can take several years to recover from.
However, if you have enough liquid capital on the side, you can use that to get by in the case of a job loss, medical event, etc. Being proactive versus reactive is always your best bet when it comes to your personal finances.
Setting Up an Emergency Fund
As far as establishing an emergency savings fund goes, you have several options. You can open a traditional savings account at your bank or credit union and fund the account with your tax return. You can also consider a high-yield savings account, which will provide you with a significantly higher level of interest compared to traditional savings accounts.
Different institutions have different rules and standards when it comes to their high yield savings accounts. Make sure you research the following:
- Deposit Minimums
- Account Balance Minimums
- Number of Permissible Withdrawals
- FDIC/NCUA Protection
As an alternative to savings accounts, you could also purchase some money market mutual funds or ETFs in a separate brokerage account. Money market investments tend to be as liquid as cash and provide slightly higher yields compared to traditional savings accounts. Here are some things to consider regarding brokerage accounts and money market investments:
- Brokerage fees
- Fund Expenses
- Fund Loads
Whatever your preferences are, you have plenty of options on the table. An emergency savings fund is an excellent use for your tax return if you don’t have one set up already.
Pay Down Debt
If you already have an emergency savings account, the next place you should look is your balance sheet, or your liabilities to be more specific. Debt on your balance sheet can be a cash flow killer, as your cash flow is the lifeblood of your personal finances.
What debt should you focus on exactly? The short answer is, it depends.
However, it usually makes sense to clean up the highest interest debt first. That debt is going to put the most strain on your monthly cash flow. If you can pay down a credit card that has an APR of 25% attached to it, consider that an immediate 25% return. When you compare that to the “average” 7-8% annualized return of the US equity markets, it starts to make a whole lot of sense.
Even if you can’t knock down the entire balance on that debt, putting a big dent in it should still be considered a big win in your book.
An alternative to paying down the high interest debt with your tax return would be paying down the debt with the lowest balance(s). For instance, you may want to pay down an outstanding balance on your smartphone financing plan. Alternatively, you might decide to put the money toward the last of your car payments or an outstanding credit card balance.
Even if these balances don’t carry high APRs, they can still be a drag on your cash flow. Seeing yourself pay down those balances can provide you with a morale boost and can motivate you to start tackling the larger debts.
Invest Your Tax Return
If you have an emergency savings account and your debt is under control, you can consider investing the funds in the market. As long as you have “earned income,” you can contribute up to $6,000 to an IRA in 2020 if you’re under 50. If you’re age 50 or above, you can contribute an additional $7,000 to an IRA. Individual retirement accounts can be great ways to supplement your primary retirement plan.
If you don’t want to be subject to the early withdrawal penalty on withdrawals from your investment account(s), you can fund a taxable brokerage account. These accounts aren’t subject to contribution limits like IRAs are. Whatever investment account and strategy you go with, you should consider:
- Your financial goals
- Tolerance for risk
- Desire to research and select your own investments
- Personal preferences
Investing in You
An alternative to investing the funds in the markets would be investing the funds in yourself. This can fall under a number of categories, such as:
- Professional designations
- Online courses
- A business or side business
- Development seminars
- Professional networking events
As they say, an investment in yourself can provide you with returns that you may not necessarily see in the capital markets.
Consider your personal circumstances. What’s important to you? What are you trying to accomplish with your career? What areas of your life can use some improvement? Who or what can help you advance?
The return on investment may not be immediate, but it may well be worth the opportunity cost of using the funds to purchase something that does not serve you.
“Return” Your Taxes…to Yourself
Lastly, you can consider treating yourself with the funds, as long as it is within reason. If you are a professional or business owner, chances are you work very hard. You have the right to enjoy time away from your craft.
If this is the case, you should consider using a “sinking fund”. This is a savings account established primarily for the purpose of funding a short-term goal, like a vacation or large purchase. Even if you don’t use the tax return for this, you can still explore the idea of starting a sinking fund for a goal that you may have in mind. All you have to do is determine what the savings goal is, set up an appropriate savings account for it and automate savings into the account from your income.
Like an emergency savings fund, the money held in a sinking fund should not be subject to the risk of the capital markets. With a short time frame to work with, preservation of capital should be the goal.
Remember to Spend Your Tax Return Wisely
Remember, the return of money to you at tax time is not an additional paycheck. It’s a return of your money that you overpaid in terms of your federal and state tax liability. With that in mind, you should carefully consider your options with the funds, as a good decision can bring you great benefits, even if the ROI isn’t measurable in terms of percentages. Carefully weigh your options and use the funds strategically.
Have questions about how to use your tax return wisely? Let us know!