Wednesday, March 09, 2011

Use Your Tax Refund Wisely, Consider the Rule of Thirds

Every year I get asked the same question by taxpayers everywhere: what should I do with my tax refund? Although every person's financial situation is different, I usually suggest the rule of thirds. Devote a third to your past, a third to your present and a third to your future. What does that mean? Devote equal portions of your refund to paying off debt (that’s the past), buying something you’ve been wanting or needing now (present) and to saving (that’s the future).

1/3 into Savings

If you are getting a refund directly deposited into your bank account, immediately move a third of it into your saving, then forget about it. Don’t delay! The longer those funds languish in checking, the higher the probability you’ll spend the money.

Consider high interest savings

To make the most of your refund, consider a high interest savings account. There are rules about minimum deposits, and how often you can withdraw money from the account, so make sure you know the rules before opening any new accounts.

Compare interest rates

If a high interest account won’t work for you, any savings vehicle will do. Just make sure you compare interest rates. A few internet searches and phone calls can make a big difference in the rate of return on your savings.

1/3 Toward Debt

Paying down debt is always a good idea and a great use for your tax refund! Typically I would recommend paying off credit cards, but if you do not have that much credit card debt then you could use the funds to pay off student loans, car loans, etc.

Pay off cards with highest interest rates first

Before you make any extra payments, be sure to look through your most recent statements to find out which cards are charging you the highest interest rates. It is always a good idea to pay off higher interest debts first!

1/3 for Fun!

Now, with the final third of your tax refund, I give you permission to go out and have fun! Celebrate paying off a little debt, and putting money into your savings account by spending some money on whatever you want. Just remember to limit your purchases to 1/3 of your tax return and not a penny more.

Think about hidden benefits of your "fun money"

There are plenty of financial moves you can make that are both fun, and smart. For instance, you might want to put the money towards a down payment on a house. Owning your own home is certainly fulfilling, and is also a tax savvy purchase because your mortgage interest may be tax deductible.

Support your local economy

If you want to avoid the guilt of feeling like you wasted a third of your refund, spend it supporting your local economy. That way you can spend the money on something fun, while knowing that you helped promote economic growth in your hometown.

Other Considerations

If you received a sizable refund (and I consider anything over $200 to be “sizeable”) from the IRS this year, you need to think about adjusting your withholding. Yes, that big check feels good, but you are waiting all year to get back money that was yours in the first place. The average tax refund is now over $3,000. That means you could have had $250 more in your pocket each month last year. Don’t wait to get your hands on your own money, adjust your withholding and use the money wisely.

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