How to Spend (or Invest) Your Tax Return

If you’re expecting a hefty refund this year from Uncle Sam, you may be tempted to spend it all on something extravagant for yourself. But it’s important to resist temptation and use that money wisely — at least most of it.

Your tax refund may feel like a windfall, but you should treat this surplus cash just like your other earnings, says David Weliver, personal finance expert and founding editor of Money Under 30.

It’s all about your attitude and making sure you set realistic expectations.

“The biggest mistake I see people make … is treating [bonuses and tax refunds] as ‘found’ money instead of earned money. Research shows we’re more likely to spend a windfall frivolously than money we’ve earned. This is especially true of money we weren’t expecting,” he says.

While tax refunds are still earned money, “the fact that it comes all at once means we associate it less with our daily efforts,” says Weliver. If your refund is what you’ve expected, or even bigger than you expected, you could be triggered to spend more of it. It’s probably not a good idea to count on having a sizable refund every year, “because that can lead to spending it before you’ve received it,” he says.

What’s the Best Use of My Tax Refund?

Before you spend anything, first you need to take stock of your debt situation. If you have credit card or consumer debt, attack that first. That’ll help your bank account — and your credit score, since high credit card balances can affect your credit-to-debt ratio. (You can see how yours is doing by viewing your free credit report summary, along with two free credit scores updated every 14 days, on Credit.com.)

“Pay it off, or at least as much of it as you can. That’s true of any debt with double-digit interest rates,” Weliver says. (You can find more tips for paying off your credit card debt here.)

When it comes to paying down larger debts, like student loans or a mortgage, the decision is more personal, and could be a good move as long as your other long-term financial goals are being met.

Should I Invest my Tax Return?

After addressing any applicable debts, make sure you have an emergency fund that will cover at least six months of expenses. That money, along with anything that will be going toward big purchases in the next three years, like a car, the down payment on a home, or a big vacation, should be kept in a savings account.

“It can be tempting to invest that money in a rising stock market, but if there’s a big market correction before you cash out, you could be forced to sell at a substantial loss,” Weliver says. “If, however, you’ve got the emergency fund and won’t need that cash in the next few years, you’ll want to invest in boring old index funds or with a robo-adviser. Invest it, forget it’s there, and go back to working hard.”

You can also make contributions to a Roth IRA or a 529 savings plan.

At the end of the day, your tax refund shouldn’t turn you into a Grinch (unless you’re digging out of credit card debt), and spending some on a splurge could be good for you.

Setting aside between 10% and 25% of your tax refund for something you really want is a great way to reward yourself and stay motivated, Weliver says.

Another option? Get involved with causes you’re passionate about and donate some of your refund to charity. There’s a bit of a bonus to that option, too: The donation could net you a tax deduction next year.

Image: AntonioGuillem