Most Americans are paying off credit card debt with their tax refund — but pad your savings account and treat yourself a bit, too, financial experts say.
’Tis the season for many happy returns.
The IRS expects more than 70% of taxpayers to get tax refunds this year, and as of March 16, the agency had issued more than 61 million refunds averaging $2,960 per worker ahead of the April 17 filing deadline. Most Americans who are carrying credit card debt (70.4%) told LendEDU in a survey released Thursday that they are using their refunds to clear the balance on those cards, with the average person using 65% of their cash back to do so. But everyone has their own idea of the best way to spend it.
Lisa, 32, who asked to withhold her last name, told Moneyish she filed early and got back around $1,600 from her New York City advertising gig. She used it to help treat herself and her boyfriend to a Nicaraguan getaway for his 40th birthday in February, springing for first-class airline tickets ($675) and staying in a higher-end beach hotel ($150 per person, per night, for five nights) than they normally would have booked.
“I have a lot of student loans. Taking that $1,600 or whatever is barely a drop in the bucket. It didn’t feel like it was making any difference,” she explained. “And this year was a special occasion.”
But Jennie Munster, 39, a chemist and mother of two in Santa Cruz, Calif., told Moneyish that she and her husband are depositing every cent of their combined $1,500 federal and $800 state return into their savings account, as they do every year.
“We slowly lose money in our account during the year (as things come up), and the tax return puts it back above what we had at the beginning of the year,” she said. “Eventually we will buy a new car, work on the house and send the kids to college.”
Most people have equally prudent plans, according to data from Principal Financial: 46% expect to save or invest it; about one in three (29%) intend to pay off or pay down longer-term debt like student loans; and another third (33%) have earmarked it for shorter-term debt like credit cards. This is what financial educators like Dr. Eric Patrick, CEO and founder of Black Market Exchange, recommend. He and his wife are putting 80% of their $3,000 return toward paying off their last credit card, with the remaining 20% ($600) going into savings.
But others — particularly younger employees — see the sudden windfall as “free money” to play with: 16% of millennials and 13% of Gen Xers plan to drop the refund on consumer products, compared to just 4% of Boomers. And millennials are much more likely to spring for a big-ticket item over other generations, with 14% planning to put their refund toward an expensive purchase, compared to just 8% of Gen Xers and 5% of Boomers.
Amy, a 35-year-old in customer service, took $500 from her $3,000 return — a little more than 16% — to buy a new couch. She’s also treating herself to more ride-sharing services, like taking a Lyft or an Uber when it’s late, rather than relying on New York’s mass transit system. “My debt is actually under way better control now, and I always look at tax returns as money for a bigger purchase,” she explained, noting that she’s “not going crazy” with the extra income.
“I could’ve bought a whole living room set,” she pointed out.
Chantel Bonneau, a financial advisor with Northwestern Mutual, told Moneyish the biggest mistake people make with their tax returns is seeing them as “free money.”
“You didn’t win the lottery. It’s not a freebie. This is your paycheck; you overpaid the government,” she said. So you should treat your refund the way you would treat a regular paycheck. Most financial planners told Moneyish that you should prioritize paying off debt, padding your savings account and investing.
“This (refund check) is forcing you to evaluate your financial strategy,” said Bonneau. “It’s an opportunity to have a proactive personal or family discussion about money, and it can be a good habit builder.”
Here’s the definitive guide to what to do with your tax refund, keeping in mind you can put it all in one place or allocate portions of it into a few of these places, for any situation you’re in:
You’re carrying a lot of debt. Northwestern Mutual reports that nearly half of Americans carry at least $25,000 in debt — and the average debt is $37,000, excluding mortgage payments. Credit card debt hit $92.2 billion nationally last year, and student loan debt is at an all-time $1.45 trillion high. “If you get $2,000, $4,000, whatever your refund is, you can use that to make a measurable impact and dent into your debt, especially high interest rate forms of debt or credit card and consumer debt that does not look great for your credit score,” said Bonneau.
That’s what one Brooklyn mom, who asked to remain anonymous, did with her $8,000 return. The 37-year-old had racked up $7,100 in credit card debt after leaving her data entry job in July to take care of her newborn, but now her balance is back to zero thanks to the refund, which she credits to having a baby and overpaying half of her salary last year toward taxes. “Being unemployed is expensive,” she said. “I’ve crawled my way out of credit debt once before, and I didn’t want to be there any longer than I had to.”
You have little to no savings. About six in 10 Americans (61%) don’t have enough cash socked away to cover a $1,000 emergency, such as an ER visit or a car repair, according to Bankrate. “Make an emergency fund a top priority if you don’t have at least three to six months worth of expenses saved up,” said Wendy Liebowitz, vice president and certified financial planner at Fidelity Investments. “You never know when you are going to have an unforeseen expense. If you need a new roof, new windows, a new car, a medical expense, or you lose your job.” And your refund is the perfect starting capital to get one rolling, or to beef up the one that you’ve been working on.
You’re behind in your retirement planning or saving for college. “If you’re not matching your employer-sponsored retirement plan, like a 401k plan, or you’ve already maxed out your 401k or employer-sponsored plan contribution, you can set up an individual retirement account, like a Roth IRA or a traditional IRA,” said Liebowitz. Putting your tax refund in there now may not seem like a lot of fun, but it’s going to earn interest over time. As NerdWallet notes, a 35-year-old with an $80,000 annual income who contributes the full $5,500 limit to a Roth IRA until retiring at 67 could end up with $518,000 in savings (assuming a 6% annual return). In a similar vein, investing the refund into a 529 will boost your college savings by earning twice as much interest (2%) as a savings account (which generally hover around 1%).
You’re eager to give back. Dr. Patrick and his wife also regularly give tithes (or a tenth of their income) to charity, although this year they’re paying down debt first. “We are very big believers in giving back,” he said, noting that a financial planner can find ways to give more. “We got a new tax preparer who actually increased my paycheck every two weeks by $300, after claiming dependents and things like that, so now that’s $300 I can donate or do whatever with,” he said. Plus, charitable donations are often tax-deductible, which can boost next year’s tax return.
You really want to treat yourself. Before you go dropping $1,500 on four “Harry Potter and the Cursed Child” Broadway tickets, deposit your refund into your savings account and sleep on it. “I’m not against using some of the money to treat yourself, especially if a small portion reduces the other urges to spend more,” said Betterment certified financial planner Marshay Clarke, who suggests an 80/20 split between doing something responsible, like saving, and something fun, like expanding your work wardrobe. “Putting x-amount in a savings account will make you feel better at night, but you’ll also be satisfied that you were still able to do something for yourself,” she said.
You got a really small return. Just because you only got a few hundred bucks instead of $3,000 is no reason to blow it on a big purchase. In fact, it means you’re doing your taxes right the rest of the year. Clarke suggests saving it the way you would if you got an especially big paycheck, which is essentially what this is. “Put it away. Remember where this refund came from: You are having too much money taken out of your paycheck every month,” she said. In fact, if you get a huge return, you may want to talk to HR to see if you should change your withholdings. “At the end of the day, I would probably want to have more money in my paycheck (each month), and know that I’m paying enough to the government, instead of waiting until the end of the year to get a refund from overpaying,” she said.
This article was originally published on April 4, 2018, and has been updated with new data.
© 2018 Dow Jones & Company, Inc. All Rights Reserved