4 Financially Smart Decisions To Make With Your Tax Return
It's that time of year! Tax season. If you find yourself in the situation where you are receiving a decent sized tax return- you should definitely make the most of it! I am all about realistic and sustainable solutions, so in that spirit I do think you should use a portion of your refund on an intentional purchase that you may have been thinking about for awhile. Perhaps you decide 25% of your return will be towards something fun, and the remainder 75% will be towards a financial goal. So, let's think about some ways that you could really make the most of this return. Here are 4 financially wise decisions you could make with your tax return money:
1. Start / Build Your Emergency Fund
Everyone, and I mean EVERYONE should have an emergency fund. If you are in debt, let's start with having a mini emergency fund of about 1 month of your living expenses. If you are debt free, you should be working to build your emergency fund to 3-6 months of living expenses. Whatever situation you find yourself in (debt or no debt), if you do not have the money saved for the thresholds I just mentioned, you should consider using your tax refund to build this fund.
2. Make a Lump Sum / Forward Payment to Debt
Consider using your tax refund to make a big lump sum payment on your debt! This is exactly what I did when I was paying off my student loans. I ended up paying off my loans 2 months ahead of my schedule, so I know that adding extra payments - like my tax refund - were really making an impact on my progress. Regardless if you are using the debt snowball (attacking smallest balance loan first) or the debt avalanche (attaching the highest interest rate loan first), make a large payment on the current loan you are working on, don't try to break it up- stay focused on making big progress on just that one. Call your debt servicer and ensure this payment will be going directly towards your principal balance!
3. Open a Roth IRA
Have you considered investing before? Time is on our side to get investing early, while we are young. There is hundred of thousands of dollars on the line when choosing to wait to invest a few years down the road (the magic of compounding interest & growth). I would recommend a Roth IRA (Individual Retirement Account). Roth simply means that you've already paid taxes on this money so once it's invested- it will grow tax free (aka you don't have to pay taxes on the money when you withdraw it down the line!)
You can open a Roth IRA account at a company like Vanguard or Fidelity (the links there will take you to step by step directions to opening an account). Once you've got the account open, you'll need to make sure you purchase an asset so that your money has the opportunity to grow. To get started, as a beginning investor, consider looking at the "Target Date" funds, you will know it's a target date fund with those words in the title and you will also see a year in the title- choose the year that represents your realistic retirement date (if you are 25yrs old you would most likely choose a 2060 target date fund, since that it 40 years out, thus making you 65 years old- an average retirement age).
Here's the info on the Vanguard 2060 Target Date Fund
Here's the info on the Fidelity 2060 Target Date Fund
What exactly is a Target Date fund? It is an index fund- meaning it holds many different stocks across the market, it's like a basket full of different type of individual stocks. Not only does the fund hold stock, but it also holds bonds! And the best part about a target date fund is that it does all the hard work for you. As you are further away from your target date the fund will hold more stock and less bonds- taking on a little more risk, for better return, since you have a long time horizon until retirement. As you near the retirement date, the fund with automatically reallocated to less stock and more bonds, becoming less risky & more stable, since you are nearing the date that you will be accessing and needing that money! This is why I think a Target Date fund is perfect for the beginning investor- you literally don't have to do any of the work besides contribute money to the Roth IRA itself :)
4. Create a Sinking Fund
A sinking fund is mini-savings account that has a very specific purpose. A sinking fund is typically created for one time big expenses. For example you car insurance that is due twice a year, or maybe an upcoming vacation! The purpose of a sinking fund is that you contribute small amounts monthly so by the time your known, big bill comes around, you have saved for it & now you don't have to come up with all this extra money or better yet go into debt to pay it!
Example- you pay $300 for car insurance in June & December (2x a year). I may contribute $50 a month to my car insurance sinking fund so that by June & December I have saved that $300 needed, instead of needing to find 100% of that money during the month of the bill!
A sinking fund can be used for ANYTHING! Think of any upcoming "out of the norm" payments or bills you may have coming up and start contributing incremental amounts to a sinking fund, to alleviate the financial pressure for the money at the time it is due!
You can store your sinking fund wherever it makes sense to you. This could include: a transfer into your savings account, you could open a HYSA for you sinking fund, you could withdraw cash & store it in an envelope! What matters is that you are putting it in a location where you will not be tempted to use it for other purposes. It is also important that if you are putting this money into a place where you have other money sitting- for example you are putting it in the same location as your emergency savings- that you keep specific and detailed track of how much of that money is allocated to your sinking fund... keep them very separate, so you don't start dipping into other money that was your emergency fund (or saved for a different goal).
I KNOW that these decisions don't seem as exciting as what you may have had in mind for your return... but I really practice what I preach & I am so thankful for the wise decisions I've made with my tax return in the past! Choose to see the bigger / long term picture with your decision making, and strive to eliminate short-term / immediate gratification purchases. Your future self will be giving you a BIG high-five for choosing to invest in yourself and in your future wisely.
Investing outside a bank or a credit union is not FDIC insured. You may lose the value in the investments you select. All information provided here is for informational purposes only. It is not an offer to buy or sell any of the securities, insurance products, or other products named.
