According to a survey by Principal Financial Group, two-thirds of employed U.S. adults are expecting a tax refund in 2017, and the average refund with be about $3,000.
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The majority of those expecting a refund plan to use it responsibly. Almost half say that they'll save or invest their refund, while 32% say they'll pay a short-term debt, such as a credit card. However, not everyone seems to have their priorities straight. For example, 21% say they'll spend the money on a big-ticket item, such as a vacation or down payment on a new car.
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With that in mind, if you haven't quite decided how to use your tax refund, here are five things to consider that can help you make a wise decision.
1. Do you have high-interest debt?
If you're getting a tax refund and have any high-interest debt, such as credit cards, this should be priority number one. Simply put, it doesn't make good financial sense to invest your money, or worse, stick it in a savings account, while credit card interest is eating a hole in your wallet.
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Think of it this way -- let's say that you owe $3,000 on a credit card at 18% interest, which means that you're paying interest at a rate of $540 just for the privilege of owing money. Even the best investors can't realistically expect annual returns of more than 10%-12% over the long run. So, using the high end of this range, an investment of $3,000 could be expected to earn as much as $360 in a year. In other words, by choosing to invest instead of paying off your credit card debt with a $3,000 tax refund, you're setting yourself up to lose $180 in a year, and probably more.
2. Could you handle an emergency expense?
To be honest, these first two items are a toss-up in terms of priority order. I'd rank "being able to handle a financial emergency" right up there with "pay off credit card debt." According to a Federal Reserve report, about half of Americans couldn't handle an unexpected $400 expense without either selling something or borrowing the money (like with a credit card). So, this is obviously a concern for many people.
If you don't have an emergency fund, consider using at least some of your tax refund for this purpose. Experts suggest that you should aim for six months' worth of expenses in a readily accessible place, but this can be quite an intimidating amount of money. However, it's fine to start small -- something is better than nothing. After all, if you set aside $400 of your refund in a savings account, you'll be better-equipped to handle unexpected expenses than half of American adults.
3. Have you been putting off any essential expenses?
The third priority, if it applies to you, is anything that you need to pay for that you've been putting off. Is your electric bill one month behind? Use your refund to get it caught up. Does your lawnmower need to be repaired before summer rolls around? Now's a good time to do it. The general point here is to use your refund to increase your financial health, and getting caught up on your expenses certainly helps you achieve that goal.
4. It may be smarter to leave your low-interest debt alone
This is more of a suggestion of what not to use your refund on. 27% of respondents to the Principal Financial survey said they planned to use some or all of their refund toward long-term debt, such as paying down their mortgage or student loans.
While this is certainly not an irresponsible financial decision by any means, I do believe there are better ways to use the money. Debts like mortgages and student loans aren't necessarily bad debts -- meaning that they tend to have relatively low interest rates compared to what you can reasonably hope to earn by investing your money.
Let's say that you have a mortgage at 4% interest. Paying it down with your tax refund is a bad financial move for the same reason I said it's silly to invest while you have high credit card debt -- the math simply doesn't work in your favor. Historically, the stock market has produced annualized returns of about 9% over long periods of time, so by borrowing at 4% with a mortgage and simultaneously earning 9% returns by investing, you come out ahead. Sure, your returns will vary from year to year, but over the long run, you should do better by investing.
5. Once the rest of your financial life is in order, it's time to invest
After you've paid off any high-interest debt, established an emergency fund, and are caught up on your expenses, then it's a smart idea to invest your tax refund. Ideally, invest it in an IRA, which will give you even more tax benefits, either immediately or years down the road. Head over to The Motley Fool's IRA Center to get started, if you don't already use one of these tax-advantaged retirement savings accounts.
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