For many people, a tax refund is better than Christmas. After hours of plugging in forms and worrying about what the IRS will say, finding out you’ll be getting money back is like winning the lottery.
But like any windfall, figuring out what to do with the money is much harder. Can you splurge and buy yourself a trip to Tahiti? Should you be responsible and put the refund toward your credit card debt? Or should you invest the money and watch it grow?
Read below for our suggestions on the best ways to spend or save your tax refund.
Pay Off Debt
The first thing to do with your tax return should be to pay off any debt you have, possibly excluding a mortgage. If you have multiple kinds of loans, you can take one of two approaches to paying off your debt.
The first strategy is the snowball method, which suggests you pay off your debt starting with the smallest balance. Once you’ve paid off that debt, you can take the amount you were paying toward it and use it for the next smallest balance.
The second method is the avalanche method, where you pay off debt in order of highest interest rate to smallest. While this method will save you the most money on interest, the snowball method has a greater chance of helping people become debt-free faster.
Save
If you don’t have any debt besides a mortgage or other low-interest loans, saving your tax refund is the next best option. An emergency fund should be your first saving priority. Many experts recommend having at least $1,000 tucked away for a rainy day, with three to six months of expenses depending on your job security.
If you already have a fully stocked emergency fund, you can put the refund in your IRA or 401k. If you have a traditional IRA or 401k, then that refund will lower next year’s tax burden, increasing your chances of getting another refund.
Some people have other savings goals, such as a down payment for a new house, renovation projects for their current home or a new car. If you have a big goal you’re trying to reach, your tax refund can help you get there sooner.
Spend
While the first two options are the most responsible ones, there’s nothing inherently wrong with spending your tax refund. It just depends on what you buy. Many people use their refund to hit the stores at the mall, but there are more practical purchases you can make.
For example, if you’ve been neglecting repairs on your 15-year-old car, now might be the time to get those taken care of. If your air conditioner needs to be serviced, using your tax refund may be the best route to take.
And if you’re still craving a new purse or tablet, then set yourself a limit. Try to use only a percentage of your refund toward your new toy and use the rest for saving or paying off debt.
Combine the Options
You don’t have to solely choose only one of the three options. You can divide your return into three parts: debt repayment, saving and spending. For example, if your return was $1,000, you can put $333 toward your credit card balance, $333 toward your emergency fund and $333 toward a surround sound system.
If you feel like being more responsible, you can eliminate the spending option to only focus on paying off debt and saving more money. This is a great idea for millennials who may be paying off student loans, but struggling to save money for retirement.
No matter what you choose, make sure to deliberate before spending—or saving—your tax refund. The more time you spend on your decision, the better it will likely be.
Zina Kumok is a writer for TraditionalIRA.com and RothIRA.com specializing in personal finance. She started covering personal finance while blogging about paying off $28,000 worth of student loans in three years. A former reporter, she has covered murder trials, the Final Four and everything in between. She has been featured in Lifehacker, Daily Worth, and Time magazines.
