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Got a tax refund? Here's why you shouldn't celebrate

April 16, 2014

Did you receive a tax refund from the IRS this year? If so, put away the bubbly and think twice before you celebrate your good fortune.

After all, that money isn't a spontaneous gift from your kindly old Uncle Sam. It was yours to begin with, and the fact that you're getting it back could simply mean you're having too much withheld from your paycheck. Think of it as money the federal government borrowed from your paycheck in 2013—interest-free.

Granted, receiving a tax refund can feel pretty nice. According to the IRS, the average refund in 2013 was almost $3,000—enough for a couple of round-trip tickets to someplace warm and sunny. But instead of spending your refund on a vacation or some other big-ticket item, consider putting that money to work. Here are three simple suggestions:

1. Boost your rainy-day fund

How long could you make ends meet if you lost your job? What would happen if you or a loved one suddenly faced a major illness?

Many Americans are just one or two missed paychecks away from financial catastrophe. Even if you're not one of them, you should have an easily accessible emergency fund capable of covering your expenses for at least a few months. (Some financial gurus suggest three to six months' worth of expenses; others push it to a full year.)

If you're woefully unprepared for a rainy day, give serious thought to setting aside your tax refund—every penny of it.

2. Lighten your debt load

Crippling debt is a depressing fact of life for many Americans. If you've run up hefty balances on your credit cards, consider using your tax refund to whittle down your debt, starting with the card that charges the highest interest rate.

Some financial advisors recommend paying off debts before creating an emergency fund. The rationale: If you run into an emergency when you're already deep in the red, you'll have fewer financial resources than if you were debt-free. Living off of credit cards for a few months isn't an attractive option, but in a worst-case scenario, it's better than having nothing at all.

While we're on the subject, be sure to pay close attention to your account balances and interest rates. Many people sign up for low-interest-rate cards, only to watch those rates jump dramatically after an introductory period. (Likewise, being late on your monthly payments may cause your rates to jump.)

3. Save more for retirement and other goals

Vanguard is an investment company, so you'd naturally expect us to suggest investing your tax refund instead of spending it. But the simple truth is that most people do need to set aside more money for retirement, college, and other important objectives.

For retirement, we advise investing 12% to 15% of your annual income (including any contributions your employer might make to a 401(k)-type plan). If you're short of that target, investing your tax refund could make a big difference. But if 12%–15% is still a stretch, just save whatever you can reasonably afford—starting now—and make an effort to increase your savings rate as opportunities arise.

Deposit your tax refund with Vanguard »

One more tip: Talk to an expert

As we noted above, a tax refund could simply mean that you're having too much money taken out of your paychecks. If that's the case, you might want to work with a professional tax advisor to determine how much really should be withheld. Or you can use the IRS's interactive Withholding Calculator* to estimate what to enter on your employer's W-4 form.

*When you click this link, you'll be leaving vanguard.com. Vanguard isn't responsible for the accuracy of information on third-party sites. Vanguard receives no remuneration for website links in this article.


Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • This article is for educational purposes only. We recommend that you consult an independent professional tax or financial advisor for specific advice.
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