It’s that time of year again! The time when Americans get their tax refunds from good ol’ Uncle Sam!
If you’ve already got your eye on a hot pair of shoes or a new tech toy I urge you to please read this first.
I recently read The Millionaire Next Door by Thomas Stanley. The entire premise of the book was to see how American millionaires actually live and spend their money. In the book he denotes one key mindset difference that separates millionaires from non-millionaires:
Non-millionaires spend windfalls of cash. Millionaires don’t.
In fact, he details how the Average Joe already knows what they are going to spend their tax refund on before they even see the money.
Do you fall into that category? Here’s why you shouldn’t spend your tax refund and what to do instead.
1. Invest your tax refund.
What do millionaires tend to do with windfalls of cash? They invest it. They are keen on having their money make more money for them. You get bonus points because any income earned from your investments is considered unrealized income (so long as you don’t touch it) and the IRS can’t tax you on unrealized income.
I can already hear the complaints, “But Amanda! Don’t I run this risk of losing all my money in the market?”
My response: you’re going to lose your money anyway if you decide to spend your tax refund. At least if you invest it you have a shot of making more money.
Now you’re probably thinking, “Okay I see your point. But I know nothing about investing.”
The remedy for that is simple: go learn.
It’s not as complicated as the financial industry would have you believe, you don’t need a shit ton of money to get started and there are more options than ever before to diversify your investments with lower fees (I’m personally a fan of index funds).
The first step is to realize investing isn’t gambling and it’s no riskier than spending your money or letting it sit in the bank making a measly 0.17% in interest.
Investing is a long-term deal where your money grows over a period of time. Over the course of the 20th century, American markets averaged a return of 8% despite two World Wars, the Cold War, the Great Depression and countless downturns we’ve had since.
“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.” ~Warren Buffett
If this right-brained English major who’s hated math since the third grade can do it, you can do it too.
One of my favorite tools for investing windfalls of cash is Betterment, a robo-advisor that makes it easy to invest.
I got a refund of $360 this year (a self-employment miracle!) and immediately invested it into exchange traded funds via Betterment.
2. Apply it to next year’s taxes (or quarterly taxes if self-employed).
If you know you’re going to owe taxes again you can apply it to your next payment. For example, those of us who are self-employed pay quarterly taxes. If we overpaid and got a refund, we can apply that refund toward our next estimated tax payment.
It’s a good way to make sure you don’t fall behind. So instead of spending your tax refund on the new iPhone just use it to lower your tax burden next year.
3. Sock it away in an emergency fund.
I’m big on emergency funds. First, because I have variable income so it’s especially important to have money socked away in the bank. Second, because I had a surprise gum surgery that caught me by surprise a couple of years ago and I know first hand what it’s like to not have enough money to cover an unexpected expense. It sucks.
Emergencies and unexpected expenses are not a matter of if, they are a matter of when. The car breaks down. You have a medical expense. Maybe a pipe bursts. This stuff happens to people all the time.
Rather than slapping the expense on a credit card and taking a whirl on the debt merry-go-round, use your tax refund to start a savings account with money you’ve set aside for emergencies.
So if you were planning to spend your tax refund this year, I strongly encourage you to save it for emergencies instead. I do this every quarter that I’ve over saved for estimated taxes. Whatever is left over goes straight into boosting my emergency fund.
4. Fund your retirement account.
This is kind of along the same lines as investing, except you really won’t be seeing this money for a very very long time.
If you’re self-employed or your employer doesn’t offer a 401(k) you’ve (hopefully) got yourself an IRA where you deposit money on a regular basis. If you’re employer does offer an employer-sponsored plan then (hopefully) you deposit a bit of money into it each pay period. This money, which is invested and takes advantage of compounding interest, is meant to serve you in your golden years when you decide to stop working.
The problem is the majority of Americans don’t have enough saved for retirement. This is old news, but it’s noteworthy because apparently we still haven’t learned.
Give your retirement account an extra boost with your tax refund. In fact, use it to help max out your contributions for the year so you can get a tax break later on. If you have a Traditional IRA you may get a deduction against taxable income in the year you mark the contributions.
Save for retirement, make more money and get a tax break? Sounds like a win all around.
(Note: Roth IRA is a little different since the taxes are paid now instead of later when you take out the money. If you’ve got any questions about tax benefits from doing some of what is mentioned above I highly recommend contacting my accountant. )
(Side Note #2: I also use Betterment for my Roth IRA. Click here to check out my complete review of Betterment.)
It would seem that there are smarter things you can do with your money than spend your tax refund. Now, I know first hand how hard the temptation can be. Last time I got a refund I bought myself an iPhone and an iPad.
However, I have since learned that I would much rather have my money make more money for me, or use it to cover emergencies down the road. Do I love my iPad? Absolutely. But peace of mind is worth a lot more to me than an iPad.