Splurge or Save: a Tax Refund Dilemma

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Splurge or Save: a Tax Refund Dilemma

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Do you get a tax refund each year? If you do, what do you do with it: splurge it or save it? Here are some things to think about:

For argument's sake let's say your expected tax refund is about $500. This money can be treated like a windfall, or a planned payment. You can use it to reduce your debts, invest it for retirement (or another financial goal you set for yourself), or you could even treat yourself to something special.

So what is the best use for your $500? Let's look at the options.

Debt Reduction

If you are carrying high-interest debt, using your tax refund to reduce your debt load may be a somewhat uninspired - yet effective - way to spend your windfall. ForSplurge or Save: a Tax Refund Dilemma example, with an average interest rate of 18.75% and assuming you make minimum payments of $10 or 4% (whichever is higher), eliminating $500 of credit card debt will save you $230 in interest over the 5 years it would have taken you to pay off the debt with minimum payments.

As a return on investment, that's a 46% profit - and more specifically works out to an average of 9.2%/year.

If you have department store credit cards (which often carry horrific interest rates that exceed 30%) you will save over $564 in interest over the 7 years it would take you to pay off the card with the same minimum payment terms as above.

That's an average return of 16%/year over the 7 years.

Investing

There is a school of thought that says reducing debt should be your first priority over investing. However, the more time your investments have to grow and compound, the larger your investments will be.

For example, $500 invested at an average annual rate of 8% will be worth $745 in five years, $1,110 in 10 years, and $2,463 in 20 years, and $5,468 in 30 years.

If you are young and have enough cash flow to cover off your debts, investing your tax refund could be quite lucrative in the long run. And since your tax refund is kind of like a windfall to begin with, it isn't a painful investment to make.

Double-Dipping

If you apply your tax refund towards a tax-deductible investment, you can get even more bang for your tax refund buck. For example, if you invest in a 401(k), your $500 tax refund could generate an additional refund of $125. That's a return on investment of 25% no matter how well (or poorly) your investment performs!

It gets better: when you use the resulting $125 refund towards debt reduction or investing, you will further maximize the value of your tax refund. Or, you could simply earmark the resulting tax refund as "splurge cash", knowing that you've done well by setting aside the original $500 tax refund for your future.

Splurging

Because some people see a tax refund as a windfall, they use it to treat themselves to something they wouldn't (or couldn't) otherwise get. This could be anything from enjoying a night on the town to buying some new clothes; from something very necessary to something simply nice to have.

If it adds to the quality of your life, then even splurging your tax refund can have value too.

Better yet, don't get a refund at all!

If you get a tax refund every year like clockwork, you're actually not maximizing your cash flow. Instead, the government is garnishing more tax than is necessary from your paychecks, hanging onto it for you (and of course earning interest with your money), then paying it back to you each year after you file your taxes - no interest earned.

Instead of enduring this forced savings plan with no real benefit, you can arrange to have less tax deducted off your paychecks so you can effectively enjoy your refund up front each month. You can get your money working for you right away, not next year when you file your taxes.

However be warned: if you are accustomed to using your tax refunds for investment or debt reduction purposes, then you need to be vigilant about doing the same thing with the tax savings on each paycheck.

Setting up an automatic savings (or debt reduction) plan which deducts money from your bank account on a regular basis is the best way to do this, since it takes the human element (which includes error and impulse) out of the equation.

So what do you do with your tax refund? Save it? Splurge it? Or both?

RELATED ARTICLES:

Cash In Hand, What to do With Your Tax Refund This Year

Tax Season It All Adds Up

What To Do With A Tax Refund

Nora DunnNora Dunn

Nora Dunn is The Professional Hobo: a full-time traveler and freelance writer. She is a contributing writer under our Life Balance blog. Having sold her business and belongings to travel, she has been on the road since 2007. She travels in a financially sustainable manner, taking advantage of creative volunteering positions. As a former certified Financial Planner, she is financially responsible for her actions along the way. She believes there is a fine balance between planning for tomorrow, and living for today. Compensated CareOne Blogger. You can follow Nora on Twitter @hobonora

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  • When I was on a DMP, I would always put the refund towards my debt.  Now that I am debt-free, depending on the size of the refund, I always invest it.  I may keep $100.00 for a nice dinner, but since I didn't have it all year, I think of it as a savings that was a nice surprise.

  • @Cheryl - It's nice to balance treating yourself with some of the money (and celebrating the windfall that it sort of is), in addition to saving the rest. Good strategy!

  • Great article..thanks so much !!  I of course, pay bills with it !

  • This sounds very intreging to say the least... So where is the "happy medium" so you don't end up paying taxes in on 4/15?

  • @Daniel - Paying bills is a good choice, especially if it helps to reduce your stress levels. Added value! :-)

    @janineh - Having to pay taxes can be a rude surprise, but looked at another way, at least you get to keep your money (and earn interest with it) in the meantime! However if you seem to consistently end up paying and don't like it, then you can ask your employer to deduct extra taxes from your paycheque so you don't have to fork over each April. Don't take this too far though; I know people who like to have extra money deducted just so they can get tax back each year...you're much better off deducting automatically into a savings account.

  • You get a tax refund because you've paid too much tax throughout the year. Your employer deducts tax from your paycheck based on your annual income, but this doesn't account for various deductions and credits that might lower your taxable income.

  • They advised me to pay down my car loan or even put the money toward the Home Equity Loan I got years ago that has a very high fixed rate. I never thought about putting it toward my mortgage; my mortgage in my mind is what it is.

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