“Oh my goodness!” I turned excitedly to my husband. “We’re getting a tax refund this year… and it’s huge!” Both of us stared at the computer screen as the number on our tax calculator continued to rise. Back then, we didn’t know what to do with our tax refund, and all we could do was watch the number grow.

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This was the first time since college I would be getting some serious tax money back. In fact, as a small-business owner, one of the harsh realities is that getting more than a few bucks refunded on my tax return is almost impossible.

But that year, we had some things in our favor: a newborn and the requisite medical bills. The Child Tax Credit reduces one’s tax burden by up to $3,600 per child.

So our moderate income ended up putting money back in our pockets — even with me being a freelancer. With our tax return deposited, we were ready to spend.

But where? On our daughter’s first birthday, a trip for our third wedding anniversary, or maybe even a down payment for a new car?

Deciding on the Best Way to Spend Your Tax Refund

About 10 percent of those receiving a tax refund will use it to make a major purchase, and 25 percent intend to spend it on everyday expenses like groceries and gas, according to the National Retail Federation.

However, we’re taking a different spending approach that I call the “We Didn’t Actually Get a Tax Refund” method.

Here’s how it works:

  1. Fill out taxes.
  2. Apply to receive your tax refund via direct deposit.
  3. Schedule the payment to a credit card for one week after the estimated direct deposit date.
  4. Pretend your refund never happened.

It’s a simple approach, but that doesn’t mean it isn’t nerve-wracking. Paying debt with a large windfall of cash can be terrifying, especially when you factor in the unknown.

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My Sister’s Story

In my sister Angela’s case, her $7,000 tax refund sat in her bank account for weeks. After talking to several financial experts, she knew the best way to spend her tax refund:

She knew she should use her tax refund to pay off a $5,000 credit card balance with a whopping 30.25 percent annual percentage rate (APR), but she couldn’t bring herself to do it.

In her mind, that money was her potential savings, her backup cash, her improve-her-home money.

And it was also hard-earned cash she had paid to the government throughout the year. Essentially “giving it away” before she could enjoy it felt like a crime. But it was the most salient, expert-recommended approach to saving money in the long run.

Other Ways to Spend

Of course, if you’ve already taking care of your debt, but still find yourself lacking in addressing other key financial concerns, you could always use your return in another fiscally responsible manner:

1. Build an Emergency Fund

Financial advisors recommend that you have enough cash in an emergency fund to cover three to six months’ worth of living expenses. This may seem like an impossible number if you’re on a tight budget, but that tax refund can be instrumental in reaching the recommended goal.

You can have a significant head start on building your emergency fund, which can help you if you ever find yourself in a financial hardship. If you’re let go from your job or are in a car accident or have a sudden medical crisis, that emergency fund will come in handy.

2. Save for Retirement

In this economy, most of us aren’t saving as much as we should be for retirement. This is when your tax refund can be extremely helpful. Saving for retirement early can save you hundreds of thousands in the long term, so start building that interest for your glorious retirement now.

3. Take Out a Savings Account

A savings account is a good, easy-to-understand, low-risk method of building interest on your money. Like the emergency fund, it can help you in the event of any unexpected financial issues, and it can also help you save up for a significant goal. Your tax refund would be a great amount to start with.

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4. Prepare a College Fund

If your debt is under control, you can always start helping with your children’s future debt. Starting a college fund, like opening a 529 plan, will help with future college costs. The earnings in a 529 plan are not subject to federal taxes and, in many cases, state taxes.

If you already have a college fund, adding to it early could help ensure that you won’t feel as stressed when your child gets ready to make their college decision. They’ll have more options available to them, and you won’t need to worry nearly as much about keeping them away from an expensive dream school.

5. Take Out Life Insurance

A final, but certainly not least, smart way to spend your tax refund is to put it toward life insurance. Term life insurance is very affordable and your tax refund can likely pay for multiple months of premiums, or you could choose to use your tax refund to pay your policy annually, which will save you a couple extra dollars.

The Bottom Line

That’s the tricky thing with a tax refund. Sure, you can spend it on the fun things in life like vacations or you can put it back into your emergency fund. The problem is that all of that requires you to already have your finances in order.

And my sister and I (along with millions of Americans) are not in this small group of people. We are not at a point where we can enjoy that tax refund. Our money has to go where our priorities are — paying down debt.

So with my $2,000 refund plus an additional $800 from our savings, in March, my family paid down $2,800 in debt. And in the long run, it will be well worth the sacrifice.

Additional background information for this article was provided by Katie L. Thomas, CPA, of Diamond J Accounting.

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