Here's how you should use your tax refund in 2021
Given recent changes in the tax code — some temporary, some not — because of the pandemic, many Americans may see larger tax refunds this year.
Last year, the average refund was $2,549, a good chunk of change that can improve your personal finances if deployed effectively.
"If you are not in a position of having to make the choice between food and shelter and saving the money, please save and/or invest the money toward your future," said Matthew Gaffey, a certified financial planner in McLean, Virginia.
Here are some ideas.
Get rid of high-interest debt
Your tax refund may be a good opportunity to finally eliminate your credit card debt or significantly reduce it at the very least. The average American had $5,313 in outstanding credit card balances in 2020, according to Experian, with an average 16.2% interest rate, per CreditCards.com. The average tax refund last year was $2,549, meaning it could wipe out nearly half of the average debt.
"Paying off the debt frees you from those payments in the future, so you can save for your future," said Nadine Marie Burns, a certified financial planner in Ann Arbor, Michigan.
Paying off or down your credit card debt would help your credit score, too, by lowering your utilization rate — the percentage of available credit you use.
"Some might say to put it all toward the debt, but I think a split would be better: Half to emergency fund and half to reducing the debt," said Kristin C. Sullivan, a certified financial planner in Denver. "That way, you have a start on savings that could help you from getting further into debt if unexpected expenses happen."
Be ready for an emergency
The last year has probably driven home the point that you may need an emergency fund to tap in case of an unexpected car or home repair or something more dire, like a job loss or trip to the ER because of a global pandemic. You may have had this cushion already, but needed to use it in 2020.
Your tax refund can help jumpstart this financial security blanket.
"If someone does not have an emergency fund equal to 6 months of household expenses (two-income families) or 12 months (one-income earner), then refunds should be put there," said Sallie Mullins Thompson, a certified financial planner in New York. "I have doubled my recommended number of months due to the pandemic."
Save these funds in an account that you can get to quickly, such as an online savings account, money market account, or a traditional savings account.
Get closer to your retirement goals
If you feel financially secure, have high-cost debt under control, and enough in your emergency fund, it’s time to think long term for your tax refund. There are two ways you can use it to increase your retirement security immediately.
IRAs: Using your tax refund, you can contribute up to $6,000 this year in your IRA accounts. If you’re 50 or older, you can put in up to $7,000 in these accounts. Roth IRAs are available to those who meet certain income thresholds, while anyone can contribute to traditional IRAs.
Health Savings Accounts (HSAs): You can also put your tax refund in an HSA, if you have one. These tax-advantaged savings account are available to you if you have a high-deductible healthcare plan. While the funds in these accounts can be used to pay for eligible medical expenses, they also double as a retirement investment tool if you don’t deplete the funds before you retire. Once you reach 65, you can withdraw funds from an HSA for any reason.
This year, you can contribute up to $3,600 as an individual or $7,200 for families. If you’re over 55, you can add an extra $1,000 above those thresholds.
Attack other debt
Say you’ve maxed out your retirement accounts. Now you can deploy your tax refund toward less costly debt, such as personal loans, car loans, and student loans. You may be able to refinance and use your tax refund to lower the principal — just make sure there are no prepayment penalties!
You can also use your tax refund to help make more than the minimum payments every month, chipping away at the principal faster and ultimately saving yourself in interest in the long run.
Car purchase: If a new car is in your 2021 plans, a tax refund can help you with the purchase. In the best case scenario, the refund plus your savings can help you avoid taking out a car loan — with a payment that averages $568, according to Experian. If you still need to borrow, at least you won't have to borrow as much if you put your refund toward the car purchase.
Down payment: Want to buy a home this year? Augment the savings set aside for your down payment using your tax refund. If you contribute at least 20% to the purchase of your home, you can avoid paying for mortgage premium insurance every month.
College plans: You can also use your tax refund to secure your child's education future by contributing to 529 savings plans. Funds in these tax-advantaged savings plans can be used for future college costs and even tuition at private K-12 schools. 529 plans are sponsored by states, with contribution and other rules varying depending on the state. In some states, contributions are deductible on state taxes.
If your finances are where they should be, then consider investing your tax refund outside of a retirement plan. You can open a brokerage account and invest in no- or low-cost mutual funds or exchange-traded funds that track the Standard & Poor's 500 index.
Rethink your refund for next year
The reason you have a tax refund this year is because you paid too much in taxes to the federal government. Many money experts bristle at this strategy because Uncle Sam doesn't tack on any interest to your tax refund.
"While many people view their tax refund as a windfall, that couldn’t be farther from the truth," said Nicole Gopoian Wirick, a certified financial planner in Birmingham, Michigan. "Receiving a tax refund is effectively giving an interest-free loan to the government."
But another big reason why you may want to avoid a huge tax refund is to increase the amount you get in your paycheck. You can use that money to build savings, invest more in your retirement plans, or pay off your debt, without waiting a year to get that money. Or, if you often find yourself trying to stretch dollars until your next paycheck drops, more money per paycheck may help you avoid that stressful situation.
Use the paycheck withholding tool online at the IRS to adjust the size of. your refund next year and your paychecks going forward in 2021. The best time to do this is right after you do this year's taxes.
Janna is an editor for Yahoo Money and Cashay, a new personal finance website. Follow her on Twitter @JannaHerron.
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