Nearly three-quarters of Americans receive tax refunds each year. For 28 percent of those refund recipients, the plan is to deposit their refund straight into a savings account, according to Bankrate.com. Another 30 percent of refund recipients, however, intend to use that money to pay off debts. Often, those debts were only taken on in anticipation of receiving their refund during tax season.
Too many Americans treat a tax refund as a form of self-insurance. They would rather pass a larger chunk of their paychecks on to the IRS each month, knowing they will receive it back in the form of a tax refund next year, than have that money go directly into their bank account.
On one hand, this is an effective way of keeping yourself from spending your entire paycheck. You are essentially treating the IRS as a locked-in savings account. You cannot get your hands on your money until the refund check comes.
On the other hand, this isn’t an efficient way to save money. As any financial planner will tell you, using tax refunds as a means of forcing yourself to save is essentially giving the IRS an interest-free loan for a year. Is that really the best way to invest your hard-earned income?
According to Bankrate.com, as many as 6 percent of Americans earning less than $30,000 per year who expected to receive a tax refund took out a loan in anticipation of receiving their refund check. Now not only have you given the IRS free money, but you have also paid a bank interest on money that would have been available to you free of charge.
Rather than giving your hard-earned income to the IRS for free, place it into an actual savings account from the beginning. Forget about how much, or how little, interest you’re earning in a savings account. The point isn’t to earn an interest, it’s to ensure that you have money available to pay for bad luck.
A 2016 survey by Go Banking Rates found that 69 percent of Americans have less than $1,000 in savings. That is a scary number when you find that at a minimum, everyone should have an emergency fund with at least three to six months’ worth of expenses saved. If you have not yet built up an emergency fund, tax refund season is a perfect time to do it.
If you do have savings already, that is your emergency fund. When you run into a tight spot, use it to get yourself back on track. Do not try to manipulate the IRS into holding your money for you while you pay a bank a premium to loan you the cash upfront. Then, when you do receive a tax refund, put it straight back into that depleted savings account so you have it for the next time an emergency strikes.
For those who already have enough saved, you can funnel your tax refund toward a retirement account, preferably a 401(k) with an employer that provides matching. The free money from your employer is a great deal. You also get to deduct the contributions you make from your taxes, and the money grows tax deferred. So in addition to putting your extra income to good use, you are also sheltering it from taxes.
There are many better uses for your money than giving it to the IRS free of charge. Rather than using tax refunds as a form of self-insurance, use that money to build up an emergency savings fund you can lean on in times of need. Once you have saved enough for yourself, you can start funneling that money toward savings for your future self in retirement. In short, almost any option is better than letting the IRS hold onto your money for you — with the exception of spending it on unnecessary items.
Ash Toumayants is the founder of Strong Tower Associates, a central Pa. retirement planning firm.