Here’s the First Thing You Should Do With Your Tax Refund

Few people look forward to tax season, but for many, there is one upside: getting a refund. The average refund hit $2,741 in 2020, according to the IRS.

Thousands of extra dollars in your pocket might have you dreaming of booking a luxury vacation abroad or buying the latest gizmos. But while these fantasies are fun to entertain, you need to take a realistic look at your financial situation to determine whether your tax refund would be better put toward financial needs.

Learn how to put your tax refund to work to your long-term benefit, rather than short-term thrill.

In a recent survey by Experian, consumer debt has grown to new heights during the pandemic, topping off at $14.8 trillion, nationwide. While credit card debt actually decreased by 9%, mortgage loans, auto loans, student loans and personal loans all reached record highs, according to Experian.

To combat debt, use your tax refund to pay down balances. Target the ones with the highest interest rates first. It will help relieve pressure put on your wallet by interest charges and increase your financial freedom. Even if you can’t pay off a balance in full, reducing your required minimum payment can help you avoid falling behind when money gets tight.

Further, lowering the amount you owe can help you relieve stress as you draw toward your goal of being debt free. After all, debt is the No. 1 cause of financial stress.

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Having three to six months’ of expenses saved up in an emergency fund is a good rule of thumb. Unfortunately, few Americans are putting away enough money in savings to manage emergencies, like an unexpected car repair or medical bill or unemployment.

If your emergency fund could use a bit more cash, put most, if not all, of your refund into savings. If you have a habit of dipping into savings from time to time, open a separate savings account at a bank you don’t frequent, and keep your emergency funds there. That way, the only way you can access your funds is by visiting that particular bank.

If you’ve decided to save your tax refund, contribute to a 401k or IRA, or other investment vehicle. Even a refund of $500 or less can be put toward investment options like individual stocks, mutual funds and dividend reinvestment plans, to earn you money over time.

If you’re a more conservative investor, consider a certificate of deposit. A three- to four-figure refund is more than enough to satisfy the minimum opening deposit requirement for this type of savings vehicle. With a CD, your money will earn higher interest than you’ll see in most savings accounts. In exchange, you’ll keep your money locked in for a set number of months or years.

One way to get guaranteed returns on your refund is by investing in yourself. Learn new skills at a community college, sign up for personal development seminars or buy fitness gear and sessions with a personal trainer. You can even use the windfall to help fund a side project, like a small business venture or Etsy store.

But if you’re really raring to spend a little money on entertainment or material goods, don’t shy away from a financial cheat day. In an article for U.S. News, financial expert Josh Felber wrote that cheat days can help you avoid overindulgence. A little bit of spending here and there helps you scratch that itch you get when you want to make an impulsive purchase. So, go ahead and buy yourself a new shirt or take a frugal vacation on your refund — just don’t go overboard.

You don’t have to gut the kitchen to invest in your home. Small fixes to keep your home in prime condition can help you avoid more expensive repairs in the future. Further, simple upgrades, like a new dishwasher or wood flooring in the living room, can modernize your home and even pay you back in the long run.

Home improvements you make can come with tax benefits when you sell your home for profit. That’s because upgrades are added onto the tax basis of your home. For example, if you purchase a home for $300,000 and make $50,000 worth of upgrades while you own it, you’ll subtract a $350,000 basis from the final sale. So, if you sell your house for $500,000, you’ll only pay taxes on $150,000 of it.

Your tax refund might be your only opportunity to make charitable contributions each year. And not only is it personally fulfilling to give money to those in need, but acting selflessly can make you happier. Plus, if you donate money to a qualified charitable organization, you can reduce your taxable income and lower your tax bill for next year.

If you’re not sure which organization you should donate to, use resources like Charity Navigator and Charity Watch to research the most trusted nonprofits. You can learn how an organization manages its funds, like how much goes toward administrative expenses and fundraising. That way, you know your money is going to a worthy cause.

More From GOBankingRates

• Money’s Most Influential: Where Do Americans Get Their Financial Advice?
• Everything You Need To Know About Taxes This Year
• ‘Rich Dad Poor Dad’ Author Robert Kiyosaki: You Should Never Say ‘I Can’t Afford That’
• Here’s How Much You Should Have in Your 401(k) Account, Based on Your Age

John Csiszar contributed to the reporting for this article.