Your client is about to get a windfall, courtesy of the IRS. What should they do with their tax refund? Splurge on something? Sock it away? Make an additional principal payment (or two) on their mortgage or their student debt?
The most important thing a tax refund recipient should do with that check from Uncle Sam is to put at least some of it into an emergency fund, said David Brinkman, investment relationship manager with Schneider Downs Wealth Management Advisors, Columbus, Ohio.
Bankrate reported the average income tax refund was $2,869 in 2019.
“We’ve heard the statistics that say, basically, that 60% of Americans could not come up with the cash to pay an unexpected $500 bill – think of a car repair or a dental bill– they would struggle to come up with that kind of cash,” he said. “So my suggestion would be that everyone needs to make sure they have some cash reserves.”
After a cash reserve has been established, the next priority for managing a windfall is to pay off high-interest debt, such as credit card debt, Brinkman advised.
The Balance website estimated the average credit card interest rate in January was 21%. Brinkman said it makes sense to pay off high-interest debt before tackling lower-interest debt such as mortgages or student loans.
If a client has adequate cash reserves and has no credit card debt, putting that tax refund into a traditional or Roth individual retirement account would be a good move, Brinkman said.
But squirreling away a windfall into a retirement fund doesn’t always coincide with people’s reactions to receiving unexpected money, he noted. “Statistics tell us Americans want to spend that money.”
What about chipping away at longer-term debt, such as the mortgage or a student loan? Brinkman said there’s nothing wrong with using a tax refund toward that debt, but using a refund to make an additional payment or two on such a long-term loan isn’t likely to have the same effect on someone’s finances as paying off high-interest credit card debt.
Brinkman isn’t an advocate for socking away every cent of a tax refund. “I think you need to take some of the money and spend it on a nice dinner out or some type of experience,” he said. “That is what tends to bring people happiness – not spending money on material things.”
But if a client is routinely seeing tax refunds in the thousands of dollars, perhaps it’s a good idea for them to take a look at their withholding, Brinkman said.
“You need to analyze how you got that big refund to begin with. Maybe this was because of higher-than-needed withholding,” he said.
Brinkman recommended clients look at their withholding each year to determine whether their current withholding rate matches their financial situation. “And it’s especially a good idea to look at it when you have a life event, like getting married or having a child,” he said.
Susan Rupe is managing editor for InsuranceNewsNet. She formerly served as communications director for an insurance agents' association and was an award-winning newspaper reporter and editor. Contact her at [email protected]. Follow her on Twitter @INNsusan.