Receiving a large tax refund can feel like you won the lottery. For many of us, it’s the biggest paycheck we receive all year. That’s a lot of “extra” money at our disposal.
In fact, about 3 in 4 Americans receive a tax refund each year1 with the average federal tax refund being between $2,300 and $3,200, depending on the state in which you live.2
Keep in mind, however, that the money you got back was yours all along. You just gave Uncle Sam a year-long loan and he didn’t have to pay any interest on it. Not a bad deal for him.
In addition, millions of Americans began receiving $1,400 stimulus checks in mid-March.3 A total of about 159 million households received payment.4
While you shouldn’t necessarily aim to get a large tax refund every year — and hopefully there won’t be a need for stimulus checks next year — here are some ideas on how to use your windfall from Uncle Sam. (Hint: Avoid “revenge spending,” i.e., the urge to splurge after the pandemic ends.5 Instead, do something smart with your refund.)
1. Pay off credit card debt
Life is expensive. And a lot of what we buy for ourselves and our loved ones goes on a credit card. Unfortunately, the average annual percentage rate (APR) for credit cards is 15.56 to 22.87 percent. It may not sound like a lot but it adds up. For example, carrying a $1,000 balance on a credit card with a 20 percent APR over a period of six months will amount to $59 in interest.6
That’s why if you have credit card debt, consider using your tax refund to go toward paying that off first.
Do you have more than one credit card, or other bills with high-interest rates? Then consider paying off the bill with the highest interest rate first and the required minimum on the others.
Chances are your credit card bill is bigger than your tax refund — and you still have other bills with interest rates attached to them. If that’s the case, you might want to use the “snowball method” — which encourages paying off a bill with the lowest balance first — if you want to feel a greater sense of progress.
2. Add to your emergency fund
Life happens. And so do unexpected emergencies. The whole world experienced one in 2020, when COVID-19 caused great financial hardship for many people. According to the Pew Research Center, 25 percent of American adults had trouble paying their bills, and 33 percent of Americans had to dip into their savings or retirement to do so.7 Lower-income adults were the hardest hit.
On the other hand, the pandemic afforded some people who had stable jobs to build up their savings because they weren’t spending money on discretionary expenses, such as eating out, vacations, and other recreation. In fact, in April 2020, the U.S. personal savings rate (the percentage of money people are saving from their disposable income) jumped to 33 percent — the highest savings rate recorded since the US Bureau of Economic Analysis (BEA) began tracking it in 1959.8
If you are one of the lucky ones with a steady income, consider using the money from this year’s tax return to build up your emergency fund. For years, financial experts have recommended that people squirrel away three to six months of expenses in a money market or savings account for that rainy day — or year. Maybe this is finally your year to do so.
Don’t feel overwhelmed by this amount. Even if your emergency savings are close to zero, any amount you start with will help. Also, your tax refund could amount to a week’s — or even a month’s — worth of expenses. That’s a great foundation to build upon.
And you’ll feel more prepared when the unexpected happens. Hopefully, in the years to come, your emergency will be more along the lines of fixing a leaking sink or getting new brakes for the family vehicle.
Access to cash (instead of a credit card) will help in either scenario.
3. Add it to your retirement savings, or jumpstart your retirement plan
Retirement might seem like a long way off. But don’t let that fool you into thinking it is. Are you on track with saving enough money for when that time comes?
A traditional or Roth IRA can help supplement your retirement savings. In 2021, if you’re under the age of 50, you may contribute up to $6,000. If you’re older than 50, that amount can increase to $7,000.9
Both contributions are about one-third to one-half of what the average tax refund is this year.
4. Start a business
While quarantining at home, perhaps you discovered you’re really good at woodworking or painting. And now you want to turn your hobby into a side business. Your tax return could serve as seed money to build up your inventory or develop a website for your new money-making gig.10
5. Save for a college education
Setting up a college funding account with your tax refund may ease the future financial burdens of an education.
Whether you go to a state or a public college, the price of a higher education is expensive. According to U.S. News data, the average annual tuition and fees at ranked colleges in 2020–2021 amounted to $35,087 for private schools, $21,184 for public, out-of-state schools, and $9,687 for public in-state schools.11
As of 2020, one out of eight Americans — about 42 million total — have students loans to help pay for their education.12
To help offset the price, consider investing in a tax advantaged vehicle, such as a 529 plan, well before your loved one heads to the halls of academia. And don’t let the high price of a college education scare you. Every dollar you save is one dollar less you have to borrow. If you’re able to contribute $250 a month (or $3,000 a year, which is the average amount of many family’s tax returns each year), your child will be well on his or her way to saving for college.13
Work with a financial professional to determine which investment vehicle is right for your situation. 529 Plans aren't the only option out there.
6. Add it to your HSA
Some health insurance features a high deductible plan that offers a heath savings account (HSA). There are some medical expenses that you might expect — like your child needing braces. But there are others that come out of left field — like your child being hit in the mouth with a baseball and needing emergency dental work.
And if you have private health insurance with a high-deductible plan, that trip to the ER (or any medical treatment) can come at a high price. And a high medical bill might mean that you have to put off something else that you were looking forward to — like a much-needed family vacation or a home remodel.
7. Invest in your home
Your tax refund isn’t going to get you a new kitchen or bathroom. But it can open the door to smaller remodeling projects that are on your home improvement to-do list.
And some improvements will save you money down the road — allowing your tax refund to make an even greater impact. For example, you might want to replace your old appliances with energy efficient models. Or, perhaps you’re ready to replace that drafty entry door.
Also, replacing a tired-looking backsplash, getting new faucets or adding a coat of paint to well-worn walls can do wonders for a home. Or sprucing up your yard with some pretty perennials will leave you feeling good.
The amount of time spent at home greatly increased in 2020. So, doing things to improve our surroundings takes on even greater meaning.
8. Invest in your family
The main reason we work is to care for the needs of our family. So, it’s no wonder that we think of their needs when we receive a large tax refund.
When we have their physical needs covered, sometimes the best thing we can provide them with is time spent together doing something fun. In fact, experiential purchases contribute more to our overall happiness than do material purchases. In other words, you can experience more happiness in “doing” rather than in “having.”14
The world spent an entire year of not “doing” much. So any experience — small or big — will probably fit the bill. How does a visit to the zoo or museum or attending a play or concert sound? You could also take a cooking or art class through community ed. Thinking bigger? Use that tax money to start a vacation fund or to contribute to an RV for a road trip to Yellowstone. Whatever experience you choose, you can revisit it again and again by talking about it with friends and family.
9. Help others
It’s more clear than ever that we need each other. Consider donating to an organization in your community that you connect with. You’ll feel good knowing you’re paying it forward. Plus, it may help with your taxes next year.