If you expect to receive a tax refund from the IRS this year, you might wonder how to spend it. It’s natural to want to go shopping or do something enjoyable when you come into a lump sum of cash, but don’t pull out your debit card too soon. Spending a lump sum of money without a financial strategy can be costly.
As nice as it is to receive a refund, it’s not an actual increase in gross income. It’s not even reported on your federal tax return. Treat your tax refund like a windfall or a measure of good luck—not like an increase in income. Far too often, when income increases, standard of living does as well. That kind of thinking and spending can lead to a point when income barely equals expenses and debt builds. In order to prevent this from happening to you, have a plan to prioritize your spending. This will help you reach your financial goals and make good use of your tax refund.
Pay Off or Pay Down Debt
Do you have too much debt to handle? The Northeast Texas Credit Union recommends that your consumer debt should be no more than 15 to 20 percent of your income. If your total consumer debt exceeds that percentage, you should consider making getting out of debt a financial goal. Use a portion of your tax refund to pay down or pay off your debts.
Add up your minimum monthly payments for expenses such as car payments, student loans, and credit cards. Total the costs. This is your gross monthly consumer expense total. Add your income from all sources, including wages, alimony, tips, and so on. This is your gross monthly income.
Take your gross monthly consumer expenses and divide it by your gross monthly income. The answer is the percentage of your consumer debt, which should not exceed 20 percent. Suppose your total consumer expenses are $400. Your total income is $2,000. Divide $400 by $2,000 to get 20 percent.
Save or Invest
One of the biggest financial mistakes people make is not setting enough money aside for emergencies, retirement, and financial goals—such as college, buying a home, or taking a vacation. If no more than 20 percent of your monthly income is being used to pay consumer debt, consider saving at least 10 percent of your tax refund—especially if you don’t have an emergency fund or supplemental retirement fund. Savings should be a financial goal for everyone.
Where To Save
If you don’t have an emergency fund equal to six months of living expenses, consider opening up a savings account or purchasing a CD or savings bonds at your bank or credit union. Some employers allow you to purchase savings bonds through payroll deductions; ask your human resource department. These accounts generally do not have high interest rates, but you’ll have easy access to your money if you need it right away. Interest rates can range from 1 to 4 percent.
Longer-term savings strategies, such as college and retirement, should be held in accounts that accumulate interest at a higher rate—for example, stocks and bonds. Talk to your banker or financial counselor to determine which investment strategy is right for you.
Spending a tax refund wisely isn’t as complicated as it may seem; once you’ve prioritized your financial goals, you can determine the best use of your refund. In most cases, you can save, pay down debt, and still have money to go shopping. Begin now to plan what you will do—your financial future is in your hands.
Image source: Flickr
Consumer Education Services, Inc. (CESI) is a non-profit service provider of comprehensive personal financial education and solutions for all life stages and for all of life’s milestones. Our goal is enhanced economic security for everyone we serve.
CESI is NOT A LOAN COMPANY