The Internal Revenue Service kicked off their tax season back on January 24th and expect more than 160 million tax returns to be filled this year with nearly 115 million taxpayers receiving a refund. With over 74 percent of Taxpayers having overpaid the IRS last year, the expected average refund is over $2,800. While tax refunds may feel like “found money”, it's important to remember that it simply represents extra money that you withheld from your paycheck that may have been unnecessary. Rather than spending a tax return on something frivolous, why not apply these funds toward improving your finances for 2022?
Pay down high-interest debt
According to creditcards.com, the average interest rate charged on credit cards was 16.13 percent. Paying off debt that is charging interest is the equivalent of achieving that rate of return on your money. For example, paying off a 14 percent credit card with your tax return is the equivalent of achieving a 14 percent return on those funds. Keep in mind, it is important to build sufficient cash reserves before sending your entire return to a creditor as a lack of cash generally leads to incurring debt.
Consider paying down the highest-interest debt first while continuing to make minimum payments on any lower interest debt you have. This may also help to reduce interest costs while expediting the payoff of debt in the future.
Few Americans maintain sufficient emergency funds. Why? Generally, because previous emergencies have sapped a large portion of savings often resulting in the reliance of debt. You may be familiar with the term “pay yourself first”. Stashing away a portion of your tax return toward an emergency cash reserve is a great way to accomplish this. Maintaining at least 3-6 months of expenses in cash may provide the safety net necessary to help cover unforeseen expenses or a job loss.
Take advantage of tax-deferred retirement savings
What If there was a way to utilize this year’s tax return to reduce your tax liability for next year? Well, investing your tax return in a pre-tax Traditional IRA, 401(k), 403(b), 457 plan and the like is a way to accomplish just that. For 2021 and 2022, taxpayers can save $6,000 in a traditional IRA ($7,000 if over age 50). Depending on income levels, you might also consider a combination of IRAs and employer sponsored plans like 401(k)s. While the maximum 401(k) contribution for 2021 was $19,500 ($26,000 if over age 50), 2022 limits increase to $20,500 ($27,000 if over age 50).
In addition to pre-tax accounts, taxpayers in lower tax brackets may want to consider a Roth IRA or Roth 401(k). While a Roth does not provide an immediate tax deduction, it may provide tax-free growth when used appropriately. Consult with your financial or tax adviser to determine whether a Roth or Traditional plan makes financial sense for you.
With over $1.4 trillion in student loan debt outstanding, earmarking a portion of your tax return toward your child’s future education expense may also be a great option. Consider assessing the benefits of a 529 plan as they can be one of the most tax-efficient ways to build funds for college. While savings used for qualified education expenses from a 529 plan grow federally tax-free, investment gains not used for college or private school may be subjected to a 10 percent penalty tax.
Lump sum contributions from a tax-return in combination with systematic monthly savings may help supercharge college savings for future expenses.
Adjust your withholdings
If you consistently receive excessively large tax returns, it may be time to speak to your tax professional about adjusting your withholdings. Remember, a large tax return is nothing more than an interest-free loan to the IRS that could have been applied to other goals. For example, a $5,000 return could provide nearly $400/month of additional cash flow that could be working for you all year in cash reserves, education funds or retirement accounts. While increasing cashflow may be beneficial, withholding too little can result in owing the IRS where penalties and interest could apply. Consider speaking to your financial and tax advisers to determine which approaches are best for your unique circumstances.
Kurt J. Rossi, MBA, CFP®, AIF® is a CERTIFIED FINANCIAL PLANNERtm & Wealth Advisor. He can be reached for questions at 732-280-7550, kurt.rossi@Independentwm.com, www.bringyourfinancestolife.com & www.Independentwm.com. LPL Financial Member FINRA/SIPC.