You won’t be getting a pat on the back from me for receiving a tax refund. Tax refunds, after all, are interest-free loans to the U.S. government that typically can be attributed to taxpayers being too conservative with their withholding tax allowances.
If you have received (or will be) a sizable refund, the good news is that you’ve effectively survived the prior year without that additional cash flow, so now you can put those recaptured funds to good use. Remember, a refund is not a gift from the IRS, it’s not a windfall to be used on (lack of) discretionary spending, it is your hard earned money, and it has fallen behind on being used to your financial betterment. In my opinion, here are the 4 best ways to make up for your money’s lost time.
1. If you Get 401K or HSA Employer Matching, Bump your Contributions by the Amount of your Refund
If your employer offers you a 401K match on your employee contributions, and you aren’t already pacing to get that maximum match, you’ll earn a very high return on topping off your 401K by the amount of your refund.
The same goes for any matching HSA funds you might get. Where should you contribute? To whichever of the two gives you the highest matching return. If you were already scheduled to maximize one of them, then move on to the next one.
Given that you can’t directly contribute to your employer-sponsored 401K or get matching HSA funds outside of payroll, in theory, the process would work like this:
- Add the amount of the tax refund to your checking account.
- Elect to bump up your 401K or HSA contributions by the amount of your refund over the next few pay periods, boosting your contributions and employer matching funds.
- Use the increased funds in your checking account to supplement your lower payroll deposits in covering basic living expenses.
- After you’ve fully contributed the refund amount, bump your contributions back to their original levels.
This act could result in a very high return of 50%, 100%, or other (depending on your employer’s matching funds) – and it’s a guaranteed positive return!
2. Pay Off Any High-Interest Debt you have, in Order of Highest APR
If #1 isn’t an option, or you are on pace to get your employer’s maximum 401K and HSA matching anyways, I would next turn to paying off high interest debts, in the order of highest APR to lowest APR. Remember, your tax refund is your money, and that money could have been used to pay off debts over the course of the prior year. Since it wasn’t, any unpaid debts were compounded over time. It’s time to reverse that.
Yours may vary, but interest rates, from highest to lowest APR, typically follow this order (by debt type):
- Payday loan
- Credit card
- Home Equity Line of Credit (HELOC) / Home Equity Loan
- Student loans
- Auto loans
- Home loans
Granted, paying off debt is not technically an “investment”, but effectively, it is. The unfortunate circumstances of building up debt has led to guaranteed compound interest working against you, and when you eliminate that debt, you are effectively getting a guaranteed positive return (by partially/fully eliminating future accrued interest).
3. Contribute to your HSA or IRA
If you’ve already received maximum matching funds in #1, or debt interest rates in #2 are lower than the returns from what I’m about to highlight, the best use of your tax refund will be to contribute even more to your HSA or make an IRA contribution. Deciding which of the two is more advantageous to contribute to is a bit complicated, and I cover it in my HSA contribution deadline post. It essentially comes down to what percentage Saver’s Tax Credit you might be eligible for on retirement contributions, and how that percentage compares to your individual tax rate (which comes back to you in the form of tax-free withdrawals from your HSA for medical expenses).
Either way, whether adding funds to your HSA for tax-free medical expense withdrawals, or getting a tax credit for IRA contributions, you’re getting a guaranteed positive return.
4. Spend Money on Products that Save you Money
If #1 – #3 aren’t relevant to you, then there are ways to get a positive ROI by investing in environmentally-friendly products that save you money. Just a few of my favorites include:
- Nest smart thermostat: the top selling, highest rated, smart programmable thermostat. Versus a non-programmable thermostat, it could save you $180+ per year.
- Philips A19 LED bulbs: a great LED bulb that I personally use that has similar light qualities and appearance to an incandescent, but one-tenth of the energy use and a cost of just over $1/each.
- Delta Low Flow Showerhead: gives you a choice between a 1.85 gallon-per-minute (gpm) and 2.5 gpm flow, without feeling like you’re not getting enough water. The 2.5 gpm setting can save a family of four $260 per year in heating costs alone vs. an older 5.5 gpm unit. That’s a 640% ROI in one year! Not to mention the huge amount of water savings.
These 4 tactics will help you turn the negative of receiving a tax refund in to a strong positive.