What Should I Do With an Unexpected Refund From the IRS?

There are a variety of reasons an Arizona taxpayer may receive a higher state or federal income tax refund than they expected:

• You may be self-employed and overpaid into the EFTPS earlier in the year. 

• A professional tax preparer may inform you of your eligibility for tax credits you hadn’t used in previous years. Some examples include things like the Earned Income Tax Credit (EITC), Child Tax Credit (CTC) or Education Credits.

• You may just be eligible for more deductions this year compared to previous tax years after unexpectedly high medical expenses, charitable donations or work-related expenses.

• You may have gone through a divorce or lost a job, causing you to drop into a lower tax bracket.

• You might have opened an IRA and contributed enough pre-tax income to drop into a lower tax bracket.

Whatever the cause, there are a seemingly limitless number of ways taxpayers can spend an unexpectedly large refund. They can put it toward the purchase of a new car, spend it on home renovations, buy new furniture or appliances, fund a vacation or put it into savings, to name just a handful of potential options.

There isn’t really a wrong way to spend a tax refund – the perceived value of any purchase is in the eye of the beholder. However, some purchases or investments might have a greater long-term impact on your financial stability and well-being than others.

Building Equity

While it’s rare for a refund to be large enough to cover the cost of a real estate purchase, like a new home or investment property, it could be put toward one of those purchases. Alternatively, you could invest that money into improving your current home or other properties you own.

Although few property improvement investments result in a reliable 100 percent ROI, the added benefits of home enhancements might still justify the investment.

Spending money on a kitchen or bathroom remodel could make living in your home more enjoyable, despite the full cost of the investment not being reflected in increased home valuation. You might know you need to make a large investment in routine but expensive home maintenance tasks, like HVAC replacement or roof replacement. A large refund might provide a rare opportunity where you have the cash on hand to cover a significant percentage of one of these expenses.

Saving for Retirement

How you save for retirement may influence the way you can invest your tax refund. People who rely primarily or solely on an employee-sponsored 401(k) won’t be able to invest their tax refund directly into that account, but there are other options.

If you don’t already have a separate self-directed traditional or Roth IRA, you could open one and put your tax refund into it. Although there are annual contribution limits on IRAs, paying into one consistently over decades and managing the funds wisely may greatly enhance the resources you have available when you retire.

Growing Money Without Sacrificing Liquidity

There are a number of common banking tools designed to encourage investment and savings. Although the annual percentage yield (APY) of most savings or checking accounts isn’t particularly high compared to returns that could potentially be earned through riskier investments, these types of financial savings accounts are very safe.

There are also some investment strategies, like a CD ladder, that allow banking customers to utilize higher yield savings tools without sacrificing all their liquidity. A CD ladder involves opening multiple CDs at different maturity dates so you predictably know when you’ll have access to more funds should the need arise. If a CD matures and you don’t need the cash, you can invest it into a longer-term CD to create a new “rung” in the ladder.

Pay Off Debt

Debts with high interest rates can make retirement more difficult for many Arizonans. Certain types of debt, like credit card debt, can be particularly difficult to overcome. Receiving an unexpected refund might offer the ideal opportunity to avoid future interest payments by paying down your debts.

On amortized debts, like auto loans or home loans, you can typically apply extra payments to the principal, reducing the total interest you’ll owe over the remaining life of the loan. Credit card debt is calculated based on the average daily balance on a monthly basis, but putting money toward revolving lines of credit will still decrease the amount you owe and reduce future interest accrual.

Do You Want to Optimize the Positive Impact of Your Refund?

Phoenix tax filers who want to ensure they’re maximizing the long-term benefits of their tax refund may want to discuss their options with the financial advisors at Fullerton Financial Planning. Our investment management and retirement planning professionals can recommend options or help you establish a plan to reach your financial goals. Schedule a consultation today.