The average tax refund is around $3,000 in America according to the IRS. Since saving, or not spending $250 a month is difficult for many, I’m OK with such a refund. With basic savings interest rates close to zero, your opportunity cost is pretty small. If we are to compare the average tax refund to the average per capita income in America of $50,000 (~$40,000 tax), $3,000, or roughly 6-7% of income is a pretty meaningful number.
Your goal should be to not only max out all your retirement plans (401K/IRA), but to also then save another 20%+ if you’ve been a long time reader of this site. With 7% out of 20% down, you’ve only got to find a way to save 13% more! Not bad at all.
There’s a big debate on whether you should have a tax refund at all, given that simply means you overpaid our incredibly inefficient and wasteful government. Since most people can’t save for cookies, I’m of the opinion that a tax refund is good for most people. Even if you did have that $3,000 in your bank at the beginning of the year, your savings interest rate will be less than 0.5% as of 1/15/2012, which is a small opportunity cost.
A QUICK MENTAL EXERCISE ON YOUR TAX REFUND
Let’s do a little exercise, shall we? Since we all make various amounts of income, take your average annual gross income over the past 3 years and multiply it by 6.5%. Are you happy, or disgusted that you will be getting a refund of that size? I’d personally be very disgusted if I knew the government was keeping that money from me all year long to go give themselves raises and spend money on frivolous things which further increase our budget deficit.
What’s important to realize is that numbers mean very little in a vacuum. You always need to be comparing one number to another, to get some sort of perspective. If you love tax refunds and make $1 million a year, $3,000 isn’t going to elevate your heartbeat one tick. However, if you got a $65,000 refund, you’d probably be ecstatic. However, mathematically, I’ll tell you that it is virtually impossible to get such a size-able refund if you make that much thanks to all the phase-outs. In fact, if you are making over $500,000 with a W2 (not a small business), you will likely be paying out the wazoo come tax time!
WHAT TO DO WITH YOUR TAX REFUND
With the perspective that $3,000 is potentially 7% of your total annual after-tax income in mind, there’s really only several things I recommend you do with your refund.
* Make it disappear. In other words, put your $3,000 into a savings account at another bank so that you cannot access it easily. Don’t go blowing your $3,000 on anything unnecessary, unless you’ve already maxed out your 401K and saved more than 20% of your income. Trust me when I tell you that your savings will grow immensely over time if you are disciplined. You’ll wake up 10 years from now and see $40,000 in the bank, just from tax refunds! Go broke to win big!
* Pay off your credit card or car loan debt. Listen, if you have revolving credit card debt that costs much more than 5%, you really have a spending problem. You do not deserve the things that you are buying because you simply don’t earn enough. It is stupid not to pay off your credit card at the end of each month and take advantage of a free 30 day grace period. Furthermore, if you have a car payment that has an interest rate of much more than 5%, and whose value is more than 10% of your gross annual income, you are also wasting your money. Seriously, these two debts alone are hurting your freedom now, and in the future. Get rid of them and follow the 1/10th rule of car buying for goodness sake!
* Help someone else. If you’ve already put on your oxygen max, use the money to help someone else put on their own. There’s nothing better than helping a friend or loved one in need. Theoretically, we can “over save” to the point where we are severely crimping our lifestyles and generating a bunch of angst in the process. Carefully tweak your savings rates each month to see what your comfortable zone is. I believe one should spend their money as they see fit, but not at the expense of their future retirement.
* Invest in yourself. This is my most favorite option because the returns on investing in your education, communication skills, language skills and so forth are multi-baggers! It always seems a little foolish to pay $1,000 for a presentation class until you confidently get on stage and wow your listeners to act. Learning another language is priceless if you are dealing with that particular region for business. I firmly don’t believe one can get enough education.
* Invest in your business. If you’ve got a small business, don’t be afraid to spend some CAPEX to provide a better experience for your customers. Obviously weigh the amount of money you will spend by your current revenue, balance sheet, margins, and payback period. I view a small business like one’s child. Nourish it and watch it grow.
DON’T BLOW YOUR TAX REFUND!
A tax refund feels good. Even though a tax refund is rightfully your money in the first place, it feels like we are getting an extra bonus for the year. And what do we tend to do with special bonuses? We tend to reward ourselves. Savings and the comfort a cash pile brings alone should be your reward. Don’t blow your refund on stupid things, unless of course you are stupid and can’t help yourself.
Oh what the heck, let’s go to Vegas and put it all on black baby! And if it doesn’t work out, there’s always next year, right? Do the right thing and save your tax refund or pay down debt you know you shouldn’t have!
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Photo: Poker winnings from cruise, 2011. Sam.