If you are expecting a large tax refund this year, it can be exciting to think about everything you can do with it. A few hundred dollars could buy you new clothes, a few thousand dollars could be a down payment on a new car, or the money could be put toward retirement or future emergencies. When should you save your refund and when can you splurge?
Never splurge your entire tax refund if you aren’t financially secure. A financially secure individual will have no debt besides a modest mortgage and will have a healthy emergency fund set aside. A good emergency fund will have a minimum of 3 months of living expenses, but preferably 6 to 8 months worth of living expenses.
If you have any debt besides a mortgage, first set aside $1,000 in a savings account. This is a short-term emergency fund that is necessary to have until your debt is paid off. It should be enough to take care of many small emergencies that may arise until your debt is paid off. After that, the rest of your refund should be put toward your debt.
If you don’t have any debt, the refund should go toward your 6 to 8 months of living expenses. This emergency fund will keep you covered for at least 6 to 8 months if you lose your job, or it can cover emergency expenses such as car problems, medical expenses, and other emergencies. Everyone should have an emergency fund, no matter how high their income level.
Tax refunds are commonly used for large expenses or upgrades. For example, if your water heater breaks, use your tax refund. If your car is barely hanging on to life, use your tax refund to get a good used car. If you have a sizeable refund, it may be enough to put down on a new house.
What about splurges? Should you always use your tax refund for boring necessities? From a perfect financial standpoint, you should put 100% of your refund toward debt or save all of it. However, you should be rewarded for good financial choices from time to time, and you should enjoy life. Spending money on fun things like big screen televisions, vacations, and new clothes isn’t always a bad thing.
If you have no debt, you have an 8 month emergency fund in a savings account, and you have a good retirement account set up, don’t feel bad about spending your refund on something fun like a cruise or a bathroom remodel. You earned it. You worked hard to stay out of debt and save enough money to be secure. It is important to spend money on things you enjoy from time to time.
If you have been paying off debt and you only have a little left, or you have a good head start on your emergency fund, you can spend some of your refund on a splurge. For example, if you have 3 months of living expenses saved up that amounts to about $6,000 and you are getting a $3,000 refund, put $2,000 in your savings account to increase your emergency fund to 4 months of living expenses and spend the remaining $1,000 on whatever you please.
If you don’t know how to manage your money, you won’t know how to best spend your tax refund. Learn about financial planning and budgeting to get your finances in order. Once you are on track, you can spend your tax refund more carefully and get the most out of it. Balance financial security with responsible spending on things you enjoy.