Tax refund: Next to the words “pay day” and “debt free,” these are my two favorite finance-related words. Whether my annual tax refund is a modest sum or a mid-size windfall, I am always happy to see my refund directly-deposited into my checking account.
I will not debate the merits of adjusting withholding to maximize your monthly income in lieu of a refund in this space. I have my reasons for continuing to maintain my withholding at its present rate to receive a refund, which I will share at a later date. Many of you will have equally valid reasons to adopt the opposite approach.
Assuming you have a tax refund coming your way, you are on the precipice of a great opportunity. As a Superhero, you must know that with great opportunity comes great responsibility! In accordance with the Superhero values of Order, Precision, and Maximization, the following flowchart will help you to answer navigate the waters of a tax refund and make significant progress on your financial journey. I recommend following the steps in numerical order.
Superhero Steps to Maximizing Your Tax Refund
1. Give a Portion of Your Tax Refund to a Charitable Organization
It should not come as a surprise to you that I am suggesting giving as the first step. As previously mentioned, Mrs. Superhero and I have placed Giving at the top of our monthly budget. Giving aligns with our values, and helping others provides us with much more satisfaction and enjoyment than buying more stuff or eating delicious food.
Mrs. Superhero and I strongly believe that giving 10% is the best way that we can make a societal contribution prior to reaching financial independence (at which time we will significantly increase our giving). We have always done this, dating back to the time when we faced a mountain of debt, and we continue to do so today, even though we are mere months away from carrying no debt other than our mortgage.
As I mentioned, we believe helping others is the most satisfying use of our money. Giving is also a strong reminder that money is not something to be hoarded out of greed. We want to value money and practice good Stewardship, but we also want to remain far removed from the love of money.
Many people reject giving in favor of keeping their money strictly to themselves. Ironically, it is usually these same people who senselessly give their money to big banks and other financiers in the form of outlandish interest payments on cars, boats, and other stuff. Personally, I would rather give in a meaningful way.
Even if you give 1% of your tax refund, you will help others and begin to change the way you view money.
2. Increase Your Savings
After supporting societal progress by giving, use your tax refund proceeds to improve your liquid savings. Unless you are an extremely high income earner or have a stable passive income stream, you absolutely must have an Emergency Fund. If you do not have one, consider this a full-blown, alarm-sounding crisis that must be addressed immediately! Statistically-speaking, there is close to a 100% chance that you will experience some form of an emergency within the next decade, so be ready!
While I recommend maintaining an Emergency Fund of at least 3-6 months of minimum living expenses, you may also wish to establish an Opportunity Fund. I do not specifically recommend amounts or figures for this fund, and you may wish to skip it entirely in favor of moving onto Step 3. However, an Opportunity Fund could allow you to make a fun, somewhat impulsive decision without any accompanying feelings of guilt or regret.
3. Defeat Your Debt Once and For All
After you have given and increased your security via your Emergency Fund, you are fully-prepared to take on the primary villain standing in the way of Financial Independence: Debt.
The sooner you eliminate your non-mortgage debts, the sooner you free a significant portion of your monthly income and simultaneously gain the freedom to invest in tax-advantaged retirement accounts. Both the Snowball and Avalanche methods are valid means to achieve debt freedom. For the purposes of this post, I am less-concerned with the method you implement to eliminate your debt; just get it done. Your tax refund may be just the push you need.
4. Invest in Tax-Advantaged Vehicles
Upon donning your Debt-Free cape, the real fun can begin. If you are free from the shackles of debt, the next optimal use for your tax refund is to maximize your retirement contributions. For the purposes of this limited space, ensure you are maximizing employer-offered plans, specifically if they offer a match, and then move onto your Roth IRA and Traditional IRA.
5. Contribute to Your Children’s College Funds
If you do not have children, skip ahead to Step 6. If you have children, you need to learn the nuances of the Coverdell ESA (Education Savings Account, also nicknamed the Education IRA) and 429 plan. The ESA has income and contribution limits (currently $2,000 per year), but I recommend you start with the ESA in most circumstances, if eligible. The important thing to understand is that minimal contributions to these vehicles will place you in a position to send your children to college without the burden of student loans if you begin early.
6. Destroy Your Mortgage Debt
Pause with me for a moment and imagine a life without a mortgage payment. What could you do with an extra $1,000 per month? $2,500? $5,000. I just felt an overwhelming sense of peace typing these words. The next time I visit my doctor and have my blood-pressure checked, I am going to visualize the wonders of a mortgage-free life to improve my numbers.
For the average family, mortgage interest represents the second-largest expense that they will pay in their entire lifetime. In some cases, total mortgage interest paid on a 30 year mortgage can be approximately 75-80% of total principal, even at today’s advantageous interest rates! The peace I felt moments ago has now been replaced by an angry adrenaline rush. I want to crush my mortgage as soon as possible! Using tax return funds to accomplish progress on an annual basis could shave several years off your mortgage, especially if you are already paying extra on principal on a monthly basis.
7. Invest in Non-Retirement Funds and/or Real Estate
If you have made it to Step 7, please allow me to offer my congratulations. With no debt whatsoever, healthy savings, and kids’ college covered, you are poised to generate significant wealth. At this stage, you may have achieved Financial Independence, depending upon your lifestyle.
I recommend using tax refund money to invest in simple index funds at this stage. A modest tax refund sum is enough to get you started with many index funds. Adopt a long-term approach, relax, and watch your money grow.
Similarly, this is the time to invest in real estate, if interested. Becoming a landlord isn’t for everyone, and paying a property manager could eat into your net profit from owning a rental property. However, a rental property can yield some of the highest annual investment returns if managed well and purchased at prices below market value.
8. Maximize the Principles of Contribution to Improve Your Home
At this stage, true fun begins. When you are financially well-poised for the future, a tax refund represents an opportunity to both invest and add joy to your life simultaneously. This is the time to make improvements around your home which increase your happiness and feature a high return on investment.
Good examples: new front door, landscaping, kitchen or bath remodel, walkway lighting
Bad examples: swimming pools, basement refinishing, utility sheds
9. Build Sinking Funds for Bucket List Items
Last, but not least, comes additional saving for specific purchases. If you make it down to Step 9 when determining how to implement your tax refund, you are an authentic Superhero. I recommend establishing separate sinking funds for a variety of priorities, such as vacations, new car purchases, secondary homes, or major home additions.
The purpose of a sinking fund is to plan for future purchases which are far off in the future. At this stage, you do not want to be fooled into getting back into debt or be caught off guard by large, necessary expenses. With a sinking fund, you won’t be financially caught off guard when your house needs a new roof, your furnace fails, or your vehicle sputters and dies.
Again, I established the Superhero Steps to Maximizing Your Tax Refund with the Superhero values of Order, Precision, and Maximization in mind. I am confident that you will not fail to cover all of your bases by following these steps. Depending upon where you are in your journey toward Restoring Order to Your World of Finances, you may wish to skip steps or modify the order. For example, renters may wish to place saving for a home down payment in the Steps. As always, let your values guide your decisions at every step of your journey.
Readers, did you receive a tax refund this year? Are you currently awaiting a refund? How did you allocate the funds?