published 2022-12-29 13:00:00 2023-01-06 13:00:00 1,3 What to Do With a Tax Refund /content/thumbnails/p-46-what-to-do-with-tax-refund-1-small.webp what-to-do-with-tax-refund It's tax season, and as the anticipation of a refund starts to build, it's easy to get caught up in the excitement of all the potential ways you could spend that extra cash. But before you start indulging in frivolous expenses, explore the psychological phenomenon of mental accounting.

What to Do With a Tax Refund

It's tax season. As the anticipation of a refund starts to build, it's easy to get caught up in the excitement of all the potential ways you could spend that extra cash. Likely, you don't lack ideas about ways to spend your tax refund. But before you start splurging on non-essential purchases or indulging in frivolous expenses, consider exploring the psychological phenomenon of mental accounting and see if you can find a better use for the money.

What to Do With a Tax Refund

Mental accounting is how we assign value and meaning to money and make decisions about spending them. Mental accounts can influence our behavior and often lead to irrational decisions. It's common for people to treat some funds as "free money" when they receive unexpected financial windfalls, such as a tax refund or a bonus at work. Because this money was not planned for or budgeted, it can feel like it's available for discretionary spending.

Every dollar is equal in value, and its source is irrelevant in managing your financial situation. Before treating yourself with tax refund money, take a step back and consider how that money can benefit you the most in the long term.

Pay Off Debt

While your tax refund may not be a magic wand that can instantly eliminate all your debt, it can help you chip away at outstanding balances and improve your financial situation.

With the extra money, you can lower your monthly payments, save on interest charges, and improve your credit score. Paying off your debt can also free up more money in your budget to save and invest for the future or to cover unexpected expenses.

Whether you have credit card balances, a student loan, or medical bills - consider using your tax refund to pay off the debt with the highest interest rate.

Start or Boost Your Emergency Fund

An emergency fund is a financial safety net essential for almost everyone. It's a stash of cash set aside for unexpected expenses and emergencies, serving as a financial buffer against life's unpredictable twists and turns. Whether you need to deal with a car repair, medical bill, or job loss, this fund can provide the financial support you need to weather the storm. Without one, even minor financial hiccups can turn into significant problems. Your tax refund can be a jumpstart for building your emergency fund or a cash infusion for bolstering an existing fund.

Related: Emergency Fund: An Important Part of Financial Planning

Fund Your Retirement

Consider using the "free money" to set aside for your post-work years by investing in a Roth or traditional IRA. By giving your money time to compound and grow, you can accumulate a more sizeable nest egg with less financial effort. If you delay, you may have to contribute more money to achieve the same results.

Remember that the power of compound interest can work in your favor, but only if you start saving early. When you reach retirement age, you will likely be grateful for the wise decision to save rather than spend on fleeting expenses.

Invest in the Stock Market

If you've been holding off on investing in the stock market because of financial constraints, your tax refund could be the perfect opportunity to start building your investment portfolio.

Before you dive in, take care of any debts or financial obligations that should take priority. Then, do your research and learn about the fundamentals of investing. Develop a clear investment strategy before you buy your first asset.

Related: Developing Your Investment Strategy

Contribute to Your HSA

Have you heard about HSAs? Health Savings Accounts (HSA) allow you to save money for medical expenses tax-free. By putting your tax refund into an HSA, you may be able to save on taxes by writing off your contribution on your next tax return and have funds available for medical expenses. You won't have to pay taxes if you use the money in your HSA for qualifying medical expenses. Or you can invest the money in your account and let it grow without paying taxes on any interest or investment gains you earn.

There are a few eligibility requirements that you need to meet to get the tax advantages of an HSA. You can learn about the requirements and the annual contribution limits in this article:

Related: Health Savings Account (HSA): Become Financially Healthier

Prepay Your Mortgage

A significant portion of long-term mortgage payments goes toward interest. Reducing the principal balance by making extra payments on your mortgage can lead to exponential savings over the life of the loan. Using a tax refund to pay down the principal balance on your mortgage is similar to putting your money to work and earning the same interest rate as the bank charges you.

Start An Education Fund

Consider a 529 plan to save money on future education costs. A 529 plan is a tax-advantaged savings plan designed to help save for future education costs. Not only can you set aside funds for yourself, but you can also save for your child or another family member.

Contributions to a 529 plan are not tax-deductible. But earnings on the investments are tax-free as long as you use them for education-related expenses. Examples of qualified expenses are tuition, books, on-campus college housing, and certain K-12 education expenses.

Put your refund to work by investing it for future college expenses. By taking advantage of the tax-free growth of a 529 plan, you can reduce the cost of your education. Or, you can give your loved ones a financial foundation and ensure that the high cost of education doesn't stand in the way of their dreams.

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