The average tax refund this year, as of early April, is $2,864, according to the Internal Revenue Service -- a sizable sum to get all at once. Deciding what to do with such a windfall can be daunting. In a 2016 survey by Capital One, 65 percent of respondents said they think it's best to use a tax refund in a practical way. But what is "practical" may depend on the situation. Respondents were evenly split on the question of saving vs. spending the money. Either way, there are many financially sound approaches to making the most of a tax refund.
One of the best investments is paying down high-interest debt. For example, the average annual percentage rate for credit card interest is over 16 percent, so paying down credit card debt is essentially like getting a risk-free 16 percent return on an investment.
Having money set aside in case of an injury, car accident, or job loss helps keep everyday emergencies from turning into financial emergencies. Many financial advisers recommend socking away at least three to six months' worth of expenses in an easily accessible savings or high-yield checking account. A tax refund can help build this emergency fund.
Some companies match a portion of a worker's contribution to an employer-sponsored retirement plan such as a 401(k). Employees who do not already contribute enough to get the maximum employer portion could consider contributing more. The rules do not allow lump-sum investments into a 401(k) -- the contribution must be deducted from a paycheck -- so use the tax refund money to make up the difference in take-home pay after increasing the amount withheld from a paycheck.
Employees may maximize employer matching in a 401(k) before contributing as much as they can, or should, for retirement. In 2018, employees can contribute up to $18,500 ($24,500 for those 50 and older). Use a retirement calculator or speak with a financial adviser to determine how much to put aside each year.
People without high-interest debt who already get the maximum allowed match from employer-sponsored retirement plans could use their tax refund money to establish or contribute to an Individual Retirement Arrangement. An IRA offers tax advantages and greater flexibility with investment options than a 401(k) plan. A traditional IRA lets account holders defer paying taxes on the money they contribute (in practice, that means taking a tax deduction equal to the amount put in the account) until money is withdrawn. With a Roth IRA, income taxes are paid on the contributions, but the principal and earnings can be withdrawn later tax-free.
Saving for retirement usually means looking decades ahead. For short-term goals such as buying a car or house, getting married, growing a family, or continuing education in the next few years, put some money into low-risk investments. They won't earn a high return, but the money will be there when it's needed.
Debt is not inherently bad, and in some cases it may make more sense to invest than to pay off debts early. For instance, if an investment offers an expected return of 5 percent and the interest on a loan is 3 percent, investing represents a net gain. But there is more risk involved, and some people may feel more secure without any debt than they would with the potential for a small return on their money.
Unlike an emergency fund, an opportunity fund allows for timely purchases without worry -- such as buying a TV or computer when it goes on sale for a short time. This could also mean having the "opportunity" to donate when a friend or family member needs financial help.
For taxpayers with a little money left over from a refund, investing in physical products may make just as much financial sense as investing in financial products. Consider buying things that pay for themselves over time by cutting other expenses. Some ideas include LED light bulbs, rechargeable batteries, or a water filter in lieu of bottled water.
Saving is not always fun, but it can buy something fun. If the practical things such as debts, emergency fund, short-term goals, and retirement accounts are covered, designate the windfall for something more exciting, such as a big vacation.