Here it is again; tax season!
While some of us, or some companies, do not have anything to pay to the taxman, most people will get a tax refund once they file their taxes. About 75% of American receive refunds or in other words, most American have too much taxes withheld from their paychecks every year. Most people actually plan to receive a refund each year and imagine these grand spending sprees as if it was free money.
Some companies even jump to the occasion to promote stuff like this eBay ad I have noticed last week:
It argues that it is time to treat yourself and holds the slogan: Turn your tax refund into your next favorite thing. This is absolutely the wrong way to approach all of this.
A tax refund is not free money from the government, it is your money you simply gave, in excess, to the government. Here is how it works:
The first step is pretty straightforward; you work and earn a wage. From that said wage, your employer then takes off source deductions, in other worlds; withholds your taxes, according to your projected earnings and sends those taxes to the government. Once you file your taxes and made all your deductions, the government then compares the taxes you paid with the taxes you should have paid. If there is an excess, you get a tax refund. If there is a deficit, they ask you to pay that difference.
It is not you who should thank Uncle Sam, he should thank you!
The IRS, for example, gladly takes your money all year long and then, once you file your return, it has 45 days to process the return and issue your refund if you are owed any. All of that without owing you any interest. Tax refunds are just interest-free loans to the government.
Actually, if you are receiving a huge refund, you are probably having too much taxes withheld at source. For Americans, you can check your W-4 form and adjust your federal income tax withholding allowances. For Canadians, you can use this calculator to see the proper payroll deductions you should have.
When eBay is promoting how this is the perfect time of the year to treat yourself, it is completely ignoring the fact that this is just your hard-earned money you overpaid the government which you are getting back.
What should you do with your tax refund?
Now that we have established that a tax refund is simply your own money, we can start exploring better ways to use it. Instead of spending on more stuff you do not need from eBay, you should treat this money as extra help to reach financial freedom. Splurging on lavish vacations or gadgets only sets you back and, most likely, would only make you temporarily happy without much long-term benefits.
Get a grip on your money
The first thing to do with your refund if you have high-interest loans, credit card balances lingering or old bills due is to pay those off. Put your refund to work and buy yourself some peace-of-mind with some big-time debt repayment.
The same goes for high-interest student loans. You could always refinance at a lower rate with companies like SoFi but the best would be to pay them off completely. The average individual income tax refund was about $3,050 in 2016, according to the IRS. This kind of money could really put a dent in your debts.
The next best thing to do, if you did not already address this, is to have at least 3-months-worth of expenses in an emergency fund. Most people go up to 6 or 9 months-worth but this would take months and months of diligent savings to get there. Putting your tax refund towards your savings not only builds up a good pillow for you to fall back on in case of emergency but also puts your money to work in a good interest-bearing account.
12% of those receiving tax refunds will spend it on a vacation, and 13% on a major purchase such as a car or television. Meanwhile, 42% say they’ll save at least part of their refund. – National Retail Federation.
Invest in your future
Once your basics are covered, start investing in yourself and try to max-out your tax-sheltered investment accounts like your TFSA (Roth IRA) or your kids RESP (529) plan. If that is already done, invest in a taxable account with brokers like Vanguard or Ally.
By investing in properly-diversified, low-cost, investments such as exchange-traded funds, you can get your tax refund to work for you and start generating long-term returns for your future self. For example, if we took the average refund of $3,050 and invest it in a simple S&P 500 fund such as Vanguard’s VOO, it would have grown to $7,655 over the last decade. That is a total return of over 151% since 2008 and that is including one of the biggest crash in American history.
If the stock market is not your thing, you could also put some of it towards your mortgage or invest in bonds, even in this low-rate environment. This is a great, secure, way to get your money working for you without taking on as much risk as an equity fund would entail.
Finally, if you really took the time and steps to improve your financial picture, maybe it is time to treat yourself a little. Instead of spending frivolously on a $1000 phone like this eBay ad suggests, spend on a something that will stay with you and make you happy.
Spend on a memorable experience or something that will change you like books, courses, or adventures. Get a new outfit, get a new haircut, or take your loved one out for a nice lunch. It does not need to be much. It does not need to be expensive. Just do something you do not do too often, something special.
This way, your tax refund will be memorable and you will never forget all that excess money you gave your government interest-free, for a whole year. 🙂