March 20, 2023

You Received a Tax Refund This Year: Now What?

By Alexander Sterba, Financial Advisor

You Received a Tax Refund This Year: Now What?

It’s estimated that 75% of U.S. filers receive a refund each year. While some may consider receiving that check a win or use it as a forced savings mechanism, a refund is not a “bonus” from the government.

What it actually means is that you overpaid the government throughout the year (and, in turn, gave them an interest-free loan). This may seem harmless, but it can impact your standard of living, your retirement savings, or even remove any interest or investment returns those funds could have generated throughout the year.

So, if you find yourself in the majority of people receiving a tax refund this year, consider these steps to plan ahead and think smart about your investments.

Start by working with your accountant to determine that you’ve claimed the correct deductibles. For example, if you claim two dependents when you file, make sure both are accounted for through the course of the year. Likewise, if you file joint, divide those two dependents between you and your partner — never should both parties claim two, or you place yourself at risk of owing at filing. Also, check your withholding on your most recent pay statements. A small percentage change can ensure you don’t overpay over the course of the next year.

Consider first using your refund to pay down any accumulated debt, particularly high interest-bearing debts like credit cards and personal loans. Think of it this way: paying off a loan at a high interest rate is a guaranteed rate of return of that payment. If your annual percentage rate (APR) is 20%, paying off the debt gives those dollars an annual rate of return which is much better than even the long-term average of the stock market.

Maybe you’d rather pay forward toward future expenses or investments. Savvy investors will look to use a cash windfall to generate other benefits. 529 accounts funded with a refund may be eligible for a small state tax deduction, depending on your state of residence. Those earnings grow tax free when used for education.  If you have earned income, adding additional dollars to a Roth IRA (subject to income limits) adds more tax savings on most withdrawals from the account after age 59.5. Using cash bonuses as a way to compound tax benefits is a smart way to make your money work for you.

Use your refund as an opportunity to funnel money toward your short- and long-term goals. Your financial planner may help you select the wisest place to put any “found money” to help you get to where you want to be. Having a plan focused on your specific goals can lead to other opportunities for excess cash.

If you have a significant expense in the next one to three years, consider investing that money in the short term. Look to buy low maturity bonds and cash equivalents instead of investing in the stock market, which is inherently volatile over short periods. In this instance, security of principal is key. 

Finally, evaluate your goals and savings targets over the last year. Did you hit the targets presented in your financial plan? Are you on track to reach your future goals?  If so, consider using your windfall to celebrate a job well done.  Celebrating wins and victories can help ingrain good habits and incentivize you to hit financial goals in the future.  Sometimes, spending can be just as healthy as saving.

As with any cash windfall, there are different ways to think about your tax refund. Work with your tax professional to ensure your withholding amounts are correct for the future and familiarize yourself with your expenses. Consult your financial plan to see how your money can work for you. At Marcum Wealth, we know a solid financial forecast can help determine the best use of your dollars.

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