Multiply the Effect of Your Tax Refund

by Kevin on March 17, 2009

We filed our taxes several weeks ago and our state is taking its time getting our money back to us. For some reason I doubt they would have the same patience if we were so slow in getting our owed taxes to them.

Nonetheless I offer a way to multiply the positive affect associated with your tax refund.

You can use your refund in three different ways, and I’m telling you about them in order of least financial risk to most financial risk. You can use your refund to pay down debt, save it, or invest it.

Make Your Tax Refund Bigger Than It Really Is

No, I am not suggesting any shady economics or credit swap derivatives to make your money grow exponentially. These may be great for the financial sector up until about last year, but there is a much more simple and rewarding way to make your tax refund grow much larger. This is also where you will see the maximum benefit from your tax refund.

It’s easy: pay down debt with your refund!

I’ll use an example from my own life. Currently every dollar of extra principle that we put down on our second mortgage results in an interest savings of three times the amount of the extra principle.

Let’s say my tax refund is $100. I put that down immediately on our mortgage. We save $300 in interest. Do you see what just happened? I made my tax refund much larger than it really was. I saved a lot of interest in the process.

Now imagine if we had $1,000 or $2,000 to put down on that debt. We could save $3,000 – $6,000 in interest costs!

Of course just putting our refund down on debt isn’t likely going to pay it off, but any interest you save in the process is great. Especially at a factor of three times whatever you pay down.

The Sliding Scale of Marginal Benefit

Of course our second mortgage debt multiplier of 3 only applies to today. Over time as we pay down the mortgage the multiplier goes down — in the next to last month of your mortgage, any additional payment will see negligible interest savings. At the front of the debt the faster you pay off, the more interest you save. The last few years of a mortgage are principle-heavy and interest-light; the opposite is true at the beginning.

If you really felt inclined you could map out how much benefit you would get throughout your repayment process. You would discover a sliding scale with maximum benefit at the beginning of the loan and minimum benefit at the very end. (If we were in the last year of our house payment we would still throw that refund onto it — the faster we own the house the better!)

Save Your Refund

Alternatively you could save your money for a rainy day. Perhaps you don’t have an emergency fund. A large tax refund can be a great foundation to that emergency fund. Throw the money into a “high-yield” savings account like ING (currently paying 1.65%). Your money will grow — slowly — over time, and if you hit a rough patch where you need to dip into savings the money will be there.

Invest Your Refund

This is where things can get a bit risky. The stock market is not a place to earn guaranteed returns. There is risk inherent in the stock market; risk that generally pays out higher rewards. However, as you have likely noted after the last year or so, you can easily lose all of your money in the stock market.

If you land a huge tax refund and you’ve knocked the first two steps out of the park — you are debt free and have saved as much as you want — you might consider putting it into an investment account. Add the money to your IRA and buy a few shares of an index fund.

Or you could go the alternative investment route and loan the money to others via Lending Club. This too is risky, but if you pick your loans right you could earn a return of 10% or so for a lower-risk borrower. (I wrote about my Lending Club experience in the past.)

Adjust Your Tax Withholdings

Remember, you don’t want a huge (many thousands of dollars) tax refund. The amount of money you owe or is owed to you falls on what I call a tax return spectrum. Being at either end of the spectrum where lots of money is changing hands (big tax return or owing a lot of money to the government) is bad. The closer to the middle of the spectrum the better.

If you were able to knock out several of your personal finance goals this year with a large tax refund you need to make adjustments. Adjust your withholding and set up an automatic saving plan to instantly remove the extra money from your paycheck. Don’t give a free loan to the government. Get your refund “back” in every paycheck. Just make sure you don’t blow it on frivolous things.

All of the above tactics can make a huge difference in the financial side of your life. Remember the biggest impact will come from paying off that debt. Every dollar of principle will save you interest. If you don’t have debt, consider saving or investing the money.

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Nate @ Debt-free Scholar March 17, 2009 at 7:33 am

This is great! I entirely agree. Do not go spend your money – use it to pay of your debt.

Thanks,
Nate

Corporate Barbarian March 17, 2009 at 10:56 am

We’re using ours to pay down debt. This will give us the best bang for the buck.

Kevin March 17, 2009 at 11:55 am

@Corporate Barbarian: Have you figured out how much it will save you in interest?

Diane March 17, 2009 at 9:49 pm

If I had debt to pay I would definitely do that first.

I will be SAVING my tax refund to supplement my emergency fund, which is better than it’s ever been, but I’m continuing to build it.

I always designate a portion of my tax refund for the year’s gift fund – birthdays & Christmas.

Under other circumstances, I might pay some on the principal of my mortgage, but with the current economy I’m saving. I can always use the money to prepay the mortgage later, if it isn’t needed.

LAL March 19, 2009 at 9:13 am

I owe the federal government. I guess I lucked out. I’m on the otherside of not paying down debt, i have to pay off the government.

Kevin March 19, 2009 at 8:48 pm

@Diane: Sounds good. As long as you have a plan for the money you are far ahead of others…

@LAL: Well I guess it’s better than them owing you money and giving you an IOU instead?

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