Tax Refund: How to Make the Most of Your Extra Money - Life's Little Pleasures and Struggles

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It’s February, and soon you’re getting a tax refund from Uncle Sam. According to the IRS, the average tax refund is $3,120, and most people receive the money within three weeks of filing their returns. That’s a nice chunk of extra money.

While it may be tempting to buy a new car, splurge on latest gadgets, or upgrade your furniture or wardrobe, it’s a better idea to spend that money wisely so you can achieve financial freedom, enjoy peace of mind, improve your quality of life, and save more money in the long run. Much of your financial and mental well-being depends on how well you manage your money.

Here are 11 smart ways how you can make the most of your tax refund this year.

Pay off your debt:

If you have a great deal of high interest debt, it would be foolish not to pay it down before you go and spend your tax refund on some other useful or meaningful things or pursuits. Using your tax refund to pay off a balance with an 21% interest rate is like earning 21% on your investments – an incredibly valuable use of the money.

Decide whether to use your refund to pay off a smaller debt completely, or use the money to free yourself from the shackles of high interest charges or kick at least a portion of that debt to the curb.

Whatever extra money you can come up with, you need to put that money towards paying off your debt so you can save more money in the long run and achieve financial freedom.

Get your peace of mind:

There is no better sleep aid than knowing you have got the cash in place to cover unexpected big expenses and income-hampering events. One of the most important defenses you have against unexpected expenses or the loss of income is a cushy emergency fund.

An emergency fund is a savings account meant to cover unexpected expenses and financial emergencies. Having an emergency fund will reduce your financial stress to a large extent. When you know that you have a cushion to fall back on in case of an emergency, a lot of your stress will go away, you will sleep better at night, and enjoy great peace of mind.

According to a study from The Pew Charitable Trusts, 55% of Americans have experienced a financial shock that left them struggling. And during this unprecedented time of Covid in 2020, almost all of us suffered some sort of financial loss or setbacks. In many cases, that hardship could have been avoided with an emergency fund.

But sadly, almost 40% of American adults wouldn’t be able to cover a $400 emergency with cash, savings, or a credit-card charge that they could quickly pay off, without borrowing money or selling something, according to the Federal Reserve’s 2018 report on the economic well-being of U.S. households. This only means far too many people are living in an extremely risky predicament.

So, while it may be tempting to use your tax refund as a down payment on a new car or expensive designer clothes, you will be much better off in the long run if you use that money to create a financial cushion to fall back on in case of an emergency. You may lose your job, have a significant pay-cut, may not be able to work because of sudden medical reasons or long-term serious illness, or face some family emergencies, or lose your home to a fire, a flood or a storm, or your car may break down.

If you want to improve your financial situation, and increase your peace of mind, you need an emergency fund big enough to cover between three and six months worth of living expenses which would include your rent or mortgage, bills, groceries, insurance payments, and other essentials.

Do you have three to six months worth of living expenses saved up? If not, put as much of your refund toward savings as possible. Unfortunately, a staggering 25 percent of Americans have nothing saved at all. An emergency fund will help you make it if you experience a personal, medical, or financial catastrophe.

While your tax refund may not be equal to three to six months’ worth of expenses, it’s a great start towards attaining your peace of mind.

Related post: An Emergency Fund and Your Peace of Mind

Boost your retirement savings

It’s never too early or too late to start saving for retirement. But the earlier you can start, the better it is for you. No one likes to worry about money — especially when it’s their time to relax and work is not an option.

Consider contributing some or all of your refund into your retirement savings fund, such as a Roth IRA. You can contribute up to $6,000 to an IRA in 2021, or $7,000 if you’re age 50 or older. Be aware that there are tax penalties for withdrawing money from a retirement account before the age of 59½. So be sure to put money in an IRA only after you have a fully funded emergency savings in place, and are sure you won’t need the money anytime soon.

Investing in your retirement now, no matter how much or how little you can manage to contribute, will make your later years less stressful and more enjoyable. Half of Americans won’t be able to maintain their standard of living in retirement. So, put your future needs before your present wants. Save your money today so you can spend it in your golden years. Your future-self will thank you.

Prepay your mortgage

You can also use your tax refund to make one or two extra payments on your mortgage to save money over the long-term. Making extra mortgage payments toward your principal balance loan can help you save thousands of dollars in interest over time, pay off your loan quicker, and build equity in your home faster.

Since so much of your payment on a long-term mortgage loan goes to pay off the interest, reducing the principal amount can have an exponential effect over the life of the loan. Every little bit of extra money you spend paying down the principal helps, potentially cutting months or even years off the length of your mortgage. Your tax refund is a great place to start expediting your mortgage repayment.

Invest in pursuing education

Another tax refund maximizing strategy is to invest in your own growth by pursuing higher/further education and additional training. Education is always a worthwhile investment. Whether you are thinking about switching careers, or you simply want to learn or develop a new skill, investing in yourself is a great way to achieve significant personal growth.

You can also consider saving some of your tax refund for your kids’ college education if you are a parent. That will be a wonderful and meaningful gift for your kids that they will always appreciate once they grow up.

Also check out: 8 Ways to Save for Your Child’s College Education

Enjoy a much needed relaxing vacation

You can also spend a part of your tax refund on a relaxing vacation that you and your family deserve. People who take a break from work and enjoy relaxing vacations have lower stress levels, less risk of heart disease, a better and improved outlook on life, and more motivation to achieve goals.

According to a Gallup study, people who “always make time for regular trips” had a 68.4 score on the Gallup-Heathway’s Well-Being Index, in comparison to a 51.4 Well-Being score for less frequent travelers. One study found that three days after vacation, subjects’ physical complaints, quality of sleep, and mood had improved as compared to before vacation. These gains were still present five weeks later, especially in those who had more personal time and overall satisfaction during their vacation.

A relaxing vacation allows you to be yourself without the external influences present in your routine life. Thus, it increases your happiness and overall life satisfaction.

Add value to your home

Your home is your biggest investment and your personal sanctuary. This is the place where you take refuge from the woes of life and the insecurities of the world outside. Here you relax and unwind, connect with your family and build memories. If it needs some additions or improvements to increase your level of comfort and overall well-being, you should spend your tax refund or extra money on those.

If there is something you need to fix, or change, or add, do so because that’s a practical and meaningful way to spend your tax refund. By adding value to your home, you add value to your life for years to come. Most homeowners are unaware that for as little as $1,000, they can pay for quite a few smaller home improvements that could greatly improve both their home and their overall quality of life.

Consider installing new fixture in the bathroom or kitchen, repainting a room or cabinets, putting in some fresh landscaping, replacing a bathroom sink, buying a new programmable thermostat, or organizing a cluttered garage or closet. All of these inexpensive improvements can increase the value of your home, while helping you and your family enjoy it more as well.

Have you been putting off those little projects around the house because you don’t have the cash? Use your refund for some of those smaller home improvements which will add value to your home and your life as well.

Save a part of your refund in your sinking fund

Building an emergency fund and/or paying off your debt should be your top financial goals. But it’s also wise to save some of your tax refund for other necessity. A good way to use your refund is to save twenty to thirty percent of your refund in your personal savings account.

Since emergency fund and retirement savings are supposed to be off-limits, where do you get money to buy a home, a new car, gifts on holidays, do some home improvements, cover wedding expenses, pay your property tax, or pursue your meaningful hobbies? From your personal savings. This fund is for your known or expected yearly expenses, not for any sudden or unexpected emergencies.

Think of a personal savings account as a comfort cushion. Some people call it “Sinking Fund”. This is your first line of defense in order to keep you from tapping into your emergency fund. If your dishwasher or microwave oven broke, you would take money from this account. But if you or your spouse lost your job, you would take money from your emergency fund. Having some money saved there can help prevent you from having to add even more money to your credit card debt.

Visit your loved ones who live far

Your quality of life largely depends on the quality of your relationships. Taking time and spending money on nurturing the most important relationships in your life should get priority. Sometimes you may need to travel to a different place to visit your loved ones such as your parents, spouse, or your siblings, to be able to spend some quality time with them, or to rekindle the relationship. That takes money.

If you have important people in your life who live far from you, and you haven’t seen each other in months or years, spending a part of your tax refund or all of it on traveling and visiting them to make beautiful memories is worthwhile.

Contribute to a health savings account (HSA)

You should have a medical fund of some sort. This account should hold enough money to cover your costly deductible, prescription costs, and co-payments. You can set up a HSA or Health Savings Account through your work, insurance, or bank. If you don’t have access to an HSA, you can choose to keep your medical savings in a separate savings account as some people do. The choice is yours.

This money is intended to cover a medical emergency, specifically something that might not be covered by health insurance. Also, this type of savings should be liquid so you can use it in case of an emergency – right away.

A HSA gives you a triple tax break – your contributions are tax-deductible (or pre-tax if through your employer), the money grows tax-deferred, and you can use it tax-free to pay out-of-pocket medical expenses in any year (there’s no use-it-or-lose-it rule).

Start a side hustle

In today’s uncertain economy, many people give themselves an added degree of security by starting a side hustle. It can be driving for Uber a few hours a week, or starting a creative home business, or turning a hobby into a money-making enterprise.

Consider using part of your tax refund to invest in some equipment for a crafting business or a new professional camera if you are interested in photography during your spare time. You can even start a blog if you love writing and sharing your knowledge and ideas with others. It doesn’t need a lot of investment. The little bit of cash you spend up front could ultimately result in a big payoff down the road, because side hustles allow many of us an outlet for creativity along with added money for the future.

Final words

You can choose to spend all your tax refund in one of these meaningful ways, or divide your tax refund into several portions and invest in all of them. The choice is yours! Just make sure that you don’t blow up your extra money on something that won’t add any value to your life.