3 Questions to Ask To Make the Most of Your Tax Refund
March 6, 2023
For fun, let’s start with a quick description of what a tax refund is. Put simply, a tax refund is the IRS returning to you money that they over-collected. Or you may have overpaid if you file estimated tax payments.
Note: Now is a good time to remind you I’m not a tax advisor, and if you have questions about official tax stuff, you should talk to a tax pro. Thank you :-)
Regardless of the situation, if you are getting a refund, the government is not giving you a generous gift. They are simply refunding the overage that was collected.
That’s important to remember since it helps you remember it’s not “free money” coming your way. You didn’t just win a small lottery, even though it can sure feel like one.
Some rough math will show that if you receive $2,100 in your IRS tax refund, if you had been paying closer to the appropriate amount in taxes each month, you would have had ~$175 more in your monthly income.
Would that have made a difference to you? It may or may not have. If you're not proactively budgeting, it would likely fall through the cracks. But if you're are budgeting, it would definitely make a difference.
Anyway, back to the tax refund.
I surveyed my audiences on LinkedIn and Instagram audiences to ask what they plan to do with their tax refund. The combined results are as follows:
- 37% plan to save/invest it
- 32% plan to put it toward debt
- 3% plan to spend it on fun stuff
- The remainder said "Other" or they plan so they don't get a refund
Which one are you in, and what do you plan to do with yours?
Before proceeding with your plan, check out these 3 questions you may not have considered about your plan.
CAMP 1: SAVE IT
If you’re saving it, now is a great time to ask yourself what you are saving for. Money that’s sitting in a big ol’ pot of money is much easier to take from, than money that is in specifically labeled buckets.
And the bigger the bucket, the easier it is to dip into. Let’s say you have $32,000 in savings. That's amazing to have that specific amount in savings, but it’s not very helpful when you're making decisions about it. Money blended together usually is.
It's much more helpful to know that $10,000 is actually for the roof you need to replace, and $10,000 is saved up for the car you desperately need to replace. This means only $12,000 is true emergency fund (the stuff you can't anticipate—job loss, health costs, etc).
This way, when you’re tempted to dip into savings, you know which bucket you are taking it from.
It’s also helpful to set goals for each category so you know when you have “enough.” This is particularly helpful for the ones who feel like it’s never enough.
CAMP 2: SPEND IT
If you plan to spend it on fun stuff, first ask whether you might actually need this money to cover annual/monthly living expenses.
If you underestimate the infrequent or annual expenses, you can start living in a la-la land (great movie, by the way) where you think your monthly life costs you $4,200 per month. This is convenient because your income is right around there.
But… when you factor in the amounts you ought to be saving per month for memberships and premiums and dental/medical care, luxuries, travel, you see that your life really costs $5,100 per month.
This means you really need $900 per month more than you make, and this tax refund could be used to cover the difference for a couple months while you figure out how and where to make adjustments.
If you have no trouble paying for your life, you're debt free, and you’re happy with your savings (3-6 months living expenses is a pretty typical recommendation for savings), you enjoy spending those dollars!
CAMP 3: PAY DOWN DEBT
If you put this toward debt, do you have a plan for ending your debt-acquisition party?
Whether what you are able to pay fully pays off your debt or not, that’s awesome. That’s less of a balance to pay interest on, and that’s a good thing given current interest rates.
It’s even more awesome if you confront your true cost of living and make sure you have a plan to live within your means. This way you don’t have to keep relying on debt. It’s demoralizing to put a chunk of money toward debt only to be sure you’re only going to go right back to debt.
So, what are you going to do with yours? Even though your tax refund is not a free financial windfall and there are definite benefits to making changes to instead have this money in your monthly life, let’s celebrate the positive since you are getting one.
The really big upshot is that you have a chunk of money at once to make bigger progress with. So what is that progress going to be for you?
We've talked about a couple scenarios of what people commonly do with their IRS tax refund.
Now may be a good time to decide if you want to change anything about your withholdings so you don’t get a return. And as discussed above, this could be a very helpful thing in your monthly budget. Contact your tax professional to learn more about how you should adjust things!
But no matter what you choose to do, making the most of your money in any amount and from whatever source starts with knowing how much your life really and truly costs.
It’s a total game-changer, and this article will help you get started!