According to the IRS, as of February 2016, the average tax refund was more than $3,000. If you've received a tax refund or are expecting one, how should you view this once-a-year boost to your bank account?
Joseph Hogue, Chartered Financial Analyst (CFA®) and founder of PeerFinance101, advises, "Don't treat your tax refund as free money or anything different than the regular income you get every two weeks. This is money you worked for but just couldn't enjoy until now because of tax withholding. Thinking of your refund as extra money leads people to blow it and miss out on a huge opportunity."
Let's say you want to take advantage of this opportunity to improve your finances. What are some wise ways to use this money? Here are five smart things to consider.
1. Put the maximum amount in a traditional IRA.
Hogue says "My favorite way to use my refund is to help max out retirement account contributions for the year. It feels good to use the money the government had to return to me to pay even less taxes."
For 2016, you may be able to put as much as $5,500 into a traditional IRA ($6,500 if you are 50 or older). This amount may be deductible, lowering your tax bill. In addition, you may check to see whether you are eligible for a saver's credit, also reducing your taxes.
2. Contribute to a Roth IRA.
After putting the maximum possible in the traditional IRA, Hogue says you could then contribute to a Roth IRA. For 2016, you can set aside as much as $5,500 per year ($6,500 if you are 50 or older) in a Roth IRA as long as you have a modified AGI of less than $117,000 if single or $184,000 if married filing jointly.
Unlike a traditional IRA, contributions to a Roth IRA are generally not tax deductible. However, money in your Roth IRA still grows tax-free as you save for retirement.
3. Pay off debt.
If you have a student loan, credit card balance, personal loan or another type of debt, you might want to apply your tax refund to one (or more) of the outstanding balances. This move can reduce your debt load and the amount you pay in interest.
There are two main ways to prioritize debt payoff. One is the snowball method, in which you apply extra funds to paying off the loan with the smallest balance. When the first loan is paid in full, you move to the next loan with the lowest balance.
Another popular way to deal with debt is the avalanche method. Using this technique, you apply extra payments to the loan with the highest interest rate. Both approaches require you to continue making minimum payments on all of your outstanding debt. As a result, you keep current with your loan obligations and accelerate your debt payoff.
Which method is best for you?
Hogue says, "You should always make it a point to pay off high-interest debt," which he defines as anything with an annual percentage rate (APR) of more than 10 percent.
After you've dealt with high-interest debt, consider the approach that makes sense to you. The debt snowball method offers a constant motivation because you may be able to pay off small accounts quickly, which reinforces the benefit of your efforts. In contrast, you'll save more money on interest using the debt avalanche approach.
If you decide to pay extra on any of your loans, let your creditors know you'd like the payments to be applied to the principal, not interest, so payments are applied to your loan balance appropriately.
4. Start or grow an emergency fund.
Another option is to create or contribute to your emergency fund, which can cover living expenses if you unexpectedly lose your job or incur unanticipated costs. For example, you may budget for routine maintenance on your car but not have the cash to pay for a breakdown. Similarly, you may have money set aside for monthly bills but have difficulty meeting obligations if you suddenly become unemployed.
The amount needed for an emergency fund can vary. According to the U.S. Securities and Exchange Commission, some people save up six months' income. For example, if you earn $40,000 annually, you might set aside up to $20,000 in an emergency fund.
5. Save for a major purchase.
Saving for something big could also be a smart way to use your tax refund. For example, you could start saving for a down payment on a house if you're planning to buy a new home soon.
Consider setting aside money in a savings account separate from your regular bank account. This way, you may be more likely to preserve your savings for your intended purpose and less likely to splurge on items you don't really need.
A high-yield savings account can be a great place to store your money. This type of account offers a higher interest rate than a more traditional savings account. For example, you could earn 1.11 percent interest on balances in a high-yield account, compared to about 0.05 percent in a regular account. However, keep in mind that these accounts aren't open to everyone, and some may require a minimum balance.
A tax refund can give you the opportunity to improve your financial condition. Consider using this money to contribute to retirement accounts, pay off debt, build an emergency fund or save for a major purchase.
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