For many Americans, tax season is as exciting as watching paint dry and as tedious as picking weeds in the garden. The best or worst moment is finalizing the calculations that determine whether you get a refund or a tax bill. Here are some tips on how you can use either outcome to improve your future financial wellness:
The Happy and Exciting Feeling of Getting a Tax Refund
Before you start planning that well-deserved trip or buying that big-ticket item, consider having your money make some financial priority pit stops that could be more beneficial for you in the long run.
1) Prioritize emergency savings: An emergency fund is a major part of making us financially resilient in the event of an unexpectedly large expense or losing income for an extended period of time. I encourage most individuals to have at least $2,000-$3,000 as a starting point and then build towards 3-6 months of necessary expenses by implementing an automated savings plan.
Consider opening a separate savings account and setting aside some or all of your refund towards an emergency fund. You can check out options at a site like depositaccounts.com.
2) Prioritize paying off debt: If you have debt with an interest rate that is north of 7%, you may want to prioritize paying that off to save you interest, time and stress. For example, putting a $2k refund as a one-time payment towards a 5k debt at 19% interest would save you about $4k in interest and cut the payoff period from 8 years to about 3.5 years if you are only making a $100 payment and don’t incur any more debt. Putting a $2k refund towards that debt every year would pay it all off in about 1 year and save you a total of about $5k in interest! You can use this DebtBlaster calculator to see how much interest you can save by using your refund to pay off debt.
3) Invest: Do you have any other goals that matter to you over the next 5 years, 10 years and beyond? How can this refund help jump start saving for goals like a down payment for a new car or home or retirement? Depending on your goal, check out what a lump sum saved and invested over a period of time can yield you in the future using a calculator like this one. Here are some additional tips on how to invest based on your goals.
4) Plan for the future and update your W-4. If you regularly receive a large tax refund, you’re essentially lending the IRS money for free. Instead, adjust your withholdings so that you ideally owe little to nothing. By doing this, you can receive your “refund” in the form of additional monthly cash flow that you can put to work immediately towards your financial goal. I also encourage you to take the extra step of using this tax withholding estimator.
The Dreadful Feeling of a Large Tax Bill
Getting a large tax bill is never fun, and it can often feel like an unexpected expense that comes at the worst possible time. Here are a few strategies to help you deal with the current financial burden and help you plan for the future.
1) Pay the bill in full by the tax filing deadline (even if you file for an extension). If for some reason you can’t afford to pay your bill by the deadline, you can still lower late filing penalties and interest fees by paying as much of the bill as possible.
2) Request a payment extension. If you are going through a financial hardship, the IRS could offer you a 6-month grace period/payment extension. You will have to demonstrate a substantial financial loss.
3) Set up a payment plan. If you are unable to pay your bill in full and don’t qualify for a payment extension, you can establish a payment plan with the IRS. There will be a small fee to set this up in addition to interest. However, a payment plan keeps you in the good graces of the IRS as long as you stick to it, and it helps you avoid additional penalties related to missed deadlines.
4) Plan for the future and update Form W-4. If you find yourself not being able to afford the lower paycheck from the increased withholdings, then it’s time to revisit your spending to ensure you are living within your means. You can use this resource to help you in those efforts.
Whatever your outcome is this tax season, I hope these tips help you realize how you can use it as an opportunity to improve your financial situation now and set yourself up for a brighter and better financial future. Consider consulting with a qualified and unbiased financial professional as well. Ask your employer if you have access to one for free through a workplace financial wellness program. In any case, I wish you all the best this tax season!