7 Smart Things to Do With a Tax Refund

Having an extra $3,000 in your pocket from a federal tax refund can make you feel rich — until you start considering the many ways you can spend it.

If you’re not going to pay down debt or save it, there are plenty of ways to spend it and get rid of that hole burning in your pocket: Go on vacation, repair the house, but a TV or computer. The list is endless.

The average tax refund in 2013 was $2,755, and about three of four filers typically receive tax refunds, according to the IRS. That’s a fair amount of money to have in your hands. But it can be a lot less money if you’ve already planned on how you’re going to spend it before you get it.

There are smart and dumb ways to use it. What you decide to do with a refund depends on how well your personal finances are in order, and if you’re a saver or a spender. Spending money is easy. It’s the savings part that’s difficult. Since a tax refund can be like found money that won’t affect your lifestyle anyway, saving it should be easy.

After talking to financial planners, certified public accountants and other tax and finance experts, we came up with seven smart things to do with a tax refund:

1. Don’t get a tax refund

This sounds counterintuitive, but avoiding getting a tax refund is a good idea if you want to keep more of your money throughout the year.

“You shouldn’t ever get a really big refund,” says Nancy Coutu, a certified financial planner and owner of Money Managers Advisory in Oak Brook, Ill. “A lot of people think that’s a good thing, but really, you’re just giving the IRS an interest-free loan for a year.”

2. Pay off credit cards

There’s no tax benefit to carrying credit card debt, so paying off such debt should be the first priority with a tax refund, financial experts say. Paying interest on credit card debt can put you further in a financial hole, and high interest rates will negate any earnings on savings that you might get if you invest the refund.

Alan Moore, a certified financial planner and founder of Serenity Financial Consulting in Milwaukee, says he’s seen more clients move from spending a tax refund on shopping sprees and vacations to paying off debt.

“When large chunks of money arrive, such as with a tax refund, the money is being put toward whatever is most stressful for the taxpayer, and many times now this is debt,” Moore says. “It is actually a great way to utilize a tax refund,since paying down high interest debt is like earning that same interest rate in the market.”He gives an example of paying off a $1,000 credit card balance at 25% interest is the same as investing the $1,000 in the market and getting a guaranteed 25% return.

You may also want to consider paying off other debts, or at least taking a big chunk out of them, says Jordan Niefeld, a certified public accountant in Miami, Fla.

“Step one is trying to eliminate all types of debt,” Niefeld says. “Or at least trying to get them down.”

3. Build an emergency fund

If you don’t have an emergency fund set up to help pay the bills if you lose your job or have a major bill such as a car repair, then a tax refund is a good start.

Having six months to a year’s worth of living expenses saved up is a smart idea, and will keep you off the street if a financial emergency happens in your life.

4. Save for retirement

Whatever type of retirement account you have, including getting started with a new program being set up by the federal government, saving for retirement is one of the smartest things to do with a tax refund. Compounding can work miracles.

“If you spend it today instead of saving it, you’re not giving up $5,000, you’re giving up that larger amount,” possibly around $20,000, says Stuart Ritter, vice president and senior financial planner at T. Rowe Price.

[pull_quote align=”left”]”No one ever saved $1 million instantly. They saved smaller amounts consistently, year over year over year,” says Stuart Ritter, a senior financial planner at T. Rowe Price.[/pull_quote]”No one ever saved $1 million instantly,” Ritter says. “They saved smaller amounts consistently, year over year over year.”

Building wealth over the long-term can be a lot more fun than blowing money as soon as it comes in.

“I always tend to recommend buying conservatively and investing it instead of going out and having a big party or something like that,” Niefeld says.

5. Open a college fund

Saving for a child’s college expenses by investing money from a tax refund every year in a college savings fund can be especially smart, Coutu says.

Putting just $2,000 a year into a college fund can add up to $100,000 if done for 18 years from a child’s birth, she says.

6. Save to buy a house

This is another area where putting aside a big tax refund every year for five or so years can lead to a big amount of money saved, and can help put a good down payment down on a house. Where you put the savings depends on your priorities.

“It’s an opportunity for people to sit down and consider what’s most important to them,” Ritter says.

7. Donate

Donating money from a tax refund to a charitable cause can continue the tax savings, Coutu says, because you’ll get a tax benefit this year that could carry over with a bigger tax refund the next year.

Unfortunately, most people are likely to spend a tax refund instead of saving it, she says. Like the child who wants to go outside and play before eating his vegetables, it’s difficult to do the serious work of saving money for the future.

“People are most likely to spend it because it’s found money. It’s like winning the lottery,” Coutu says.

How do you plan  to spend your tax refund? Tell us in the comments section below.