Nearly half of all Americans expect to get a tax refund in 2023 and already have plans in place for using the money. So far this year, refunds have averaged $2,753.[1] That figure’s nothing to sneeze at, but it does represent a reduction from last year and reflects the end of pandemic-era tax credits and deductions. A tax refund is often thought of as found money and a gift from the IRS, but nothing could be further from the truth. A refund is the repayment of an interest-free loan that you, the taxpayer, have given the government. Getting money back means more tax dollars than necessary were withheld during the year from your paycheck, pension, or other taxable income. It gives the folks in Washington an opportunity to spend your money, which meant you didn’t have it to meet expenses, invest, or pay down debt. Most financial professionals will tell you the best scenario is neither to owe the IRA money at filing nor to get money back. I generally advise clients to adjust their withholding, so their tax liability or refund is as close to zero as possible at the end of the year.
Qualifying for a big refund didn’t have such negative consequences when inflation and interest rates were low, but multiple Fed rate hikes have made borrowing money expensive and increased the yield on savings. If you’re due a big refund in 2023, you can’t rewrite history, but you can use those dollars wisely to reduce credit card debt, increase your emergency savings, or both. More than 50% of this year’s tax refunds will be used like this, according to a Bankrate.com survey of U.S. adults conducted in February.
Reduce credit card debt.
With inflation surging over the past few years, you may have been been making ends meet by charging everyday expenses and paying them back over time. Unfortunately, this is a terrible economic environment for increasing credit card debt. In February, Bankrate calculated the average annual percentage rate on credit cards to be 19.14% — the highest rate since 1985 when tracking started.[2]
One of the best ways to use your tax refund is to reduce high-cost debt, including credit card balances, unsecured loans, car loans, and variable rate student loans. You won’t be able to eliminate the debt immediately, but you can kickstart a plan to reach that goal and gain valuable momentum.
Build up short-term savings to cover emergencies.
Higher living costs have made it more difficult to save money for unexpected needs. Most U.S. adults don’t have the savings to cover a $1,000 emergency expense, according to a recent Bankrate Emergency Fund Report. In February, 41% of people surveyed by Bankrate said they had less money in emergency funds than they did in 2022, and 36% said their debt exceeded their emergency savings. [3]
Having liquid savings to draw on for emergencies is particularly important right now because it reduces reliance on credit cards. Fortunately, savers are getting robust returns on interest-bearing accounts, especially high yield savings account. If you’re opening an account for the first time or looking for a new one, be sure to shop around for a combination of competitive rates, low balance requirements, and low monthly maintenance fees.
How much emergency money is enough? A general rule of thumb is to have the equivalent of 3 to 6 months of take-home pay. Most people have nowhere near this amount and a tax refund offers a relatively painless way to start catching up.
Save more for retirement or higher education.
Even if you’ve been saving diligently for retirement and higher education, there’s always more you can do. Consider using your refund to open an IRA to supplement your employer-sponsored retirement plan or add to a 529 plan to cover future college costs. Both offer tax advantages that can enhance long-term growth.
If you’re working and want to reduce your future tax refunds, consider changing your withholding by claiming more allowances on Form W-4. For help, use the Tax Withholding Estimator tool at IRS.gov. If you’re retired and have multiple sources of taxable income, you may need to change Form W-4V, Form W-4P, and contact your IRA custodian. Retirees and filers who have a complex tax situation can benefit from consulting with financial and tax professionals before they make a move. Don’t, however, drag your feet. Although you can modify withholding at any time, the sooner you do it, the greater it’s impact will be during the current tax year.
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