Most people aren’t at a loss for ideas on how to spend a cash windfall. With bills to pay, savings accounts to fortify and even the most modest of vacations to plan, the dilemma is deciding what to drop from the list.
The IRS reports that the average tax refund so far this year is close to $3,000 — not crazy, change-your-life-forever money, perhaps, but definitely in improve-your-financial-standing territory. How best to deploy those dollars?
1. If you’re paying double-digit interest on any debt
The opportunity to wipe a high-interest debt from the books should be irresistible. Instead, using a refund to pay off a credit card balance feels far from a joyous event and more like a big financial killjoy.
Nothing could be further from the truth.
Paying off a $3,000 balance sitting on a credit card charging 15% interest amounts to $450 in savings. Guaranteed.
A 15% guaranteed return is certainly an investment worth bragging about, which is why the advice to use an IRS windfall to pay off high-interest debt seems to kick off every serious article ever written about what to do with a tax refund.
2. If your car/HVAC/ACL/job security isn’t in the best shape
Wanton spending on big-ticket splurges isn’t what sends most people into the spiral of debilitating debt. The more common culprit is being unable to cover the costs of just a few unexpected setbacks.
An emergency fund is an investment in your current and future financial stability.
Being able to pay for a medical emergency or keep up with bills during a jobless stint means not having to use high-interest plastic, borrow money at loan-shark rates or damage your credit due to late payments and defaults.
This money needs to be easily accessible, in a checking or savings account, but also somewhere you’re not tempted to skim dollars to pay for day-to-day stuff. An emergency-only account at a separate bank is a good option. Look into online-only institutions that tend to pay higher interest rates than their bricks-and-mortar peers.
3. If your 2021 shopping list is filling up
Is Junior’s college tuition tab on the horizon? Got plans for a kitchen renovation? A family vacation from the kitchen renovation? A tax refund provides seed money for expenses that are a few calendar pages away. For any purchase you can see coming in the next two to five years, you’re looking for an investment that …
- Pays a decent return — at least something better than the zero-point-practically-nothing most savings accounts pay these days
- Doesn’t put your money at risk of losing value
- Keeps the funds liquid, not tied up someplace you can’t get to it earlier, if absolutely necessary
A bank certificate of deposit is an appropriate investment for money you need in the next couple of years. Based on interest rates as of April, with a $3,000 investment, expect around a 1.75% to 2% rate over one year, or anywhere from 2.25% to 2.75% if you let the bank hold on to your money for five years.
In a bank CD, your money earns higher rates of return than in a plain old savings account, and it’s insured against loss by the Federal Deposit Insurance Corp. The trade off: The best-paying accounts have higher deposit requirements. Also be aware of early withdrawal penalties if you dip into the account before the term expires.
4. If your retirement savings are thin and you think you missed the stock market’s heyday
You know those “woulda, coulda, shoulda” investments you never made? Returns like the nearly 12% you could have earned by investing 2015’s tax refund in the S&P 500?
Don’t dwell on missed opportunities, and instead focus on supersizing your long-term gains. Any money you can afford to let ride for at least the next five years is a candidate for a more aggressive investment strategy — investing in the stock market.
Consider the last nine decades: In roughly seven of every 10 years the stock market has gone up. Sure, that means that in the other three years the market went down, which is why you shouldn’t invest money you know you’ll need in the nearer term. But when averaged out the market has delivered returns of roughly 10% annually over the last century.
You don’t even have to be a stock-picking whiz to earn returns like that. Simply buy an S&P 500 index mutual fund and let your savings ride.
5. If multiplying your money and lowering your taxes at the same time sounds good
If there was an MVP of tax-refund investment strategies, stashing the money in an individual retirement account would get the trophy. In addition to providing a way to invest in the stock market, an IRA comes with considerable tax benefits.
Depending on the type of IRA you choose, savers can get either an upfront tax break (via tax-deductible contributions to a traditional IRA) or catch a break later (a Roth IRA provides tax-free withdrawals in retirement). With both types, you pay no taxes on investment growth while the money is in the account.
Contributions to an IRA are capped at $5,500 annually (or $6,500 for those over age 50). Even if you’re able to seed the account with only a few hundred dollars, it’s worth it to lower your tax bill for next year.
Dayana Yochim is a writer at NerdWallet. Email: dyochim@nerdwallet.com. Twitter: @DayanaYochim.
The article 7 Smart Ideas for What to Do With Your 2020 Tax Refund originally appeared on NerdWallet.