What should you do with your tax refund money?

This time of year, roughly three in four Americans have an opportunity to save, invest, pay down debt — or splurge. Federal income-tax refunds give most households some extra cash to work with. Are some uses of the money better than others?

Refunds this year are running about $400 per household lower than last year, owing largely to the scaling back or elimination of a few tax credits. Still, refunds for the current filing season are averaging about $3,100 per recipient, according to recent numbers from the Internal Revenue Service. While down from average refunds of $3,500 at this time last year, it’s still the largest chunk of change that some people will receive all year.

So what to do with the money? With some credit card interest rates now topping 20%, and with more people struggling to pay bills and meet living expenses, it’s not surprising that debt repayment is a priority. Of nearly 1,600 people who responded to a February survey by Lending Tree, 35% said they would use refund money to pay bills or debts, the highest response.

Next came the 32% who planned to save the money, followed by 14% who didn’t yet know, 11% who planned to put the money toward an vehicle or home down payment, 10% who planned to take a vacation and 10% who planned to spend the money in other ways.

Another 8% were earmarking their refunds for some type of retirement saving, 6% who planned to invest specifically in the stock market and 4% who intended to donate the money to charity. Respondents were allowed to choose multiple answers.

Which debts should you pay off early?

Jim Simpson, a certified public accountant who oversees five free taxpreparation sites through the VITA or Volunteer Income Tax Assistance program, argues that paying off debt is especially wise if you’re facing an interest rates of 8% or higher, which is typically the case with credit cards but not necessarily with mortgages or auto loans.

Why 8%? Because that’s a reasonable rate of return to expect on longterm investments, such as a mix of stocks and bonds, Simpson noted. But while the investment rate isn’t guaranteed, paying down debt with rates that high essentially guarantees a return of that magnitude, he argues.

Grace Lau, an investment manager at Benefit Financial Services Group in Phoenix, said she too would pay down high-interest debts first, especially like those on credit cards or auto loans that don’t offer an interest deduction. With mortgages, which do offer a tax deduction, it’s a trickier question that also depends on what returns you could earn by saving or investing the money. For example, if your mortgage rate is 4% or less, you might be better off putting the money into a certificate of deposit or Treasury bill yielding close to 5%, she said.

A one-time tax refund of around $3,000 might not go far in paying down a mortgage, but it could make a difference if you commit to this as a long-term strategy. “If you expect a refund of around $3,000 a year and apply it to your mortgage every year, it would shave off a lot of time and money,” said Randy Watsek, a certified financial planner with Raymond James in Somers, New York.

How to split your options

In the LendingTree survey, respondents were allowed to make multiple choices. That’s often a practical solution that allows taxpayers to balance spending and debt-repayment needs with saving and investing.

“There’s nothing wrong with spending a windfall on something fun if you’re already saving enough to meet your long-term goals and have a sufficient emergency fund; however, putting some extra money away for your future self is always wise,” said Dana Anspach, a certified financial planner and founder of Sensible Money in Scottsdale.

“If you’re stuck trying to figure out what’s best, try splitting it across the options such as one-third each to pay down debt, save for the future and splurge today.”

Many Americans don’t have even $1,000 stashed away in a savings account to meet emergencies. A tax refund can help to seed such an account, and then you can keep adding to it.

“Even if it is only $10 a week, develop a habit of saving,” Simpson suggests. “Soon the habit will kick in and give you much more satisfaction as you watch your savings grow.”

But it’s important to consider your upcoming liquidity needs, Watsek added. If you expect to face a layoff or other income interruption, for example, it might make sense to use the refund money to prepare for that. “Otherwise, you might need to borrow it again,” he said.

Like many other advisers, Watsek suggests compiling an emergency fund capable of meeting three to six months of regular living expenses.

Tax tricks can make your money go further

In terms of tax benefits, not all savings and investment options are created equally. Individual Retirement Accounts, employer-sponsored retirement plans and Health Savings Accounts are some of the vehicles that do offer tax breaks in various ways.

For example, employer 401(k)-style retirement plans essentially allow workers to deduct the amount of their contributions, while providing tax-deferred growth for as long as the money stays in the account. Many companies add money to encourage employees to invest.

While you can’t earmark a tax refund directly into an employer retirement plan, you could put extra money into the account from your paycheck while using the refund to pay for living expenses. For example, you could have your human resources department make a large, one-time deduction from your paycheck, put that money into the 401(k) plan and “use your tax refund to supplement the loss of that one paycheck,” Simpson suggests.

A similar strategy is possible for triple tax-sheltered Health Saving Accounts, which allow contributions to go in untaxed, allow tax-sheltered compounding in the meantime, then allow tax-free withdrawals if the money is used for an array of health expenditures. This is a “practical method for deducting medical expenses,” Simpson said.

Lower-income people can use refund money to set up or add to a traditional or Roth IRA using the Saver’s Credit, a federal tax break that “effectively gets you free government money if your income is low enough,” Simpson said.

For 2023, the credit is at least partly available for singles with adjusted gross income up to $36,500 and married couples earnings up to $73,000.