That deposit the IRS puts into your bank account might seem like a sudden windfall, but in reality it’s money that belonged to you all along.
“A refund is created by prepaying your taxes in excess of the amount due,” Cordasco says. “The government does not pay you interest on these overpayments, so in essence you are making an interest free loan to the government.”
Too often, though, people treat their refund as if it were a piece of unexpected good fortune, and they splurge, spending the money on expensive trips or trivial items with no lasting value.
“This is the worst way to spend a refund,” Cordasco says. “Ideally, you would like to invest this found money for the future and to create wealth.”
The IRS is running behind on processing tax returns this year, which means millions of Americans still haven’t received their refunds, leaving them with more time to decide how to spend the money when it does arrive. If that’s you, Cordasco suggests a few alternatives to frivolous spending:
Increase your retirement savings. It’s always a good idea to have extra money in your retirement savings, so this should be your first consideration, Cordasco says. Deposit the money into your IRA or Roth, or use it to increase your contributions to your workplace 401(k). That money can then grow in the coming years and help make your retirement even more secure, he says.
Create or add to a college fund. If you’re a parent concerned about the future cost of college, this tax refund could help, Cordasco says. As with retirement savings, the money will work for you and years from now when your child is ready to apply for college, this year’s tax refund plus any interest it has gained will be available to help with tuition or other expenses.
Stash it away for an emergency or other unforeseen needs. Somehow you have managed to get by without this money so far, so why not continue to do so, Cordasco says. You never know when you might need a major car repair or have to pay a hefty hospital bill, so use the refund to create an emergency fund or simply save it for some future, undefined need that’s likely to be a wiser purchase than anything you would pick up in a spending splurge.
Finally, Cordasco says it might be time to rethink whether you want a tax refund at all.
While many Americans leap for joy when they learn a large refund is coming their way, he says a more appropriate emotion might be regret. After all, that’s money that could have come in handy the year before, but was sitting out of reach in the government’s bank account.
“Ideally, you would want to review your withholdings or estimates annually to make adjustments that eliminate or minimize the amount of your refund,” Cordasco says. “This means you will have access to these funds throughout the year.”