If you’re expecting a tax refund this year, it’s important to remember that it’s not free money — just delayed income.
That said, anytime you receive a large lump sum of cash, it can help you jumpstart your finances. That’s why it’s important to find smart ways to use your tax refund, like building an emergency fund or knocking out debt.
Without a plan, it’s easy for that money to blend into your normal spending instead of moving you closer to your goals. That’s why it helps to decide where your refund will go before it even hits your account.
How to allocate your income tax refund
Let’s say you receive a $5,000 tax refund. I’m going to share one way you could divide that money to move you closer to your financial goals.
Keep in mind, this is just an example. Your situation might look different. For example, you may receive a smaller refund, have no debt to worry about, or already have a fully funded emergency fund. If that’s the case, you can shift your numbers accordingly.
Emergency fund
An emergency fund is designed to help you cover unexpected costs, like an emergency medical bill or unexpected car repair, so you don’t have to rely on debt. You can even earn a little interest income by stashing that money in a high-yield savings account.
If you don’t already have a buffer, consider putting $2,000 toward your emergency fund. Experts often recommend saving three to six months of expenses, but even $2,000 can help with surprise costs.
Pay down debt
Debt can slow down your progress toward your other financial goals. By paying off your debt, you can free up room in your budget and save money on interest. In fact, the interest rate you’re paying is essentially your guaranteed rate of return when you pay it off.
If you receive a $5,000 tax refund, consider putting $1,500 toward high-interest debt. You can use either the debt snowball or avalanche method to decide which balances to tackle first.
Related Post: Debt Snowball vs. Debt Avalanche: What’s the Best Strategy
Future expenses
We all have those sneaky periodic expenses that don’t show up every month and throw off our budgets. For example, you might have a friend’s wedding or routine car maintenance coming up.
Setting aside $1,000 of your tax refund in a separate account can give you a head start on these costs. When they come around, you’ll already have the money waiting. From there, you can continue contributing small amounts each month to replenish the funds.
Guilt-free fun spending
Now that you have the responsible stuff taken care of, you can use the rest for fun. Enjoying your money is part of a healthy financial life.
Consider taking $500 from your tax refund to spend however you’d like. You might decide to upgrade your wardrobe, buy a new piece of tech, or go to a concert. Whatever you choose, you can do it without feeling guilty since you’ve already covered your priorities.
How not to spend your tax refund
Your tax refund can help you build momentum toward your financial goals, but it can also disappear quickly if you’re not careful. Here are a few common mistakes to avoid:
Upgrading your lifestyle
Your tax refund is a one-time payment, so it’s usually not ideal to use it for a big purchase that permanently increases your monthly costs. For example, making a down payment on a car with high monthly payments or moving to a more expensive home. While $5,000 may seem like a lot of money, you can spend it fast on lifestyle upgrades.
Investing without a financial foundation in place
Investing can be a smart move, but you need a strong financial foundation first. That means having at least $2,000 or one month of expenses in an emergency fund and paying off high-interest debt. Once you cover those basics, you can start researching investment strategies and consult a financial advisor about how to get started.
Letting it go to waste
If a large sum, like a $5,000 tax refund, falls into your lap, it’s an opportunity to improve your life. Without a plan, though, it can disappear into impulse spending before you realize it. Used intentionally, that money could help you build an emergency fund, reduce debt, and make room for other financial goals.
How Lunch Money can help you allocate your tax refund
Planning out smart ways to use your tax refund is easier when you can see the full picture of your finances. With Lunch Money, you can assign your refund to specific categories — whether that’s your emergency fund, debt payments, sinking funds, or fun spending.
When you can see your monthly expenses in one place, it becomes simpler to decide how much to allocate to each goal. Once the refund hits your account, you can track where it goes and make sure your spending aligns with your plan.
This tax refund guide was inspired by this YouTube video from our very own Jacob Wade. In it, he shares some additional tips for using Lunch Money to make better financial decisions. If you’re ready to take control of your finances, you can start a free 30-day trial of Lunch Money and plan for this year’s tax refund.
FAQs
If you’re still unsure how to use your tax refund, the answers below could help you decide.
What are some smart ways to use your tax refund?
One of the smartest ways to use your tax refund is to divide it among your emergency fund, high-interest debt, and upcoming expenses. After building your financial foundation, you can set aside a portion for fun spending.
Is it better to save or pay off debt with your tax refund?
That depends on your situation. If you don’t have an emergency fund, I recommend setting aside at least $2,000 or one month’s expenses first. From there, you can focus on paying down debt or split the refund between both goals.
Should I invest my tax refund?
Investing can be smart, but only after you’ve established your emergency fund and paid off any high-interest debt. This will ensure you are financially stable before you start investing.
Can I use my tax refund for a big purchase?
Yes, as long as it’s planned and aligned with your goals. The key is to avoid purchases that create debt or ongoing expenses.
