Thank Yourself Later: The Benefits of Saving Your Tax Refund

According to a recent Bankrate.com survey, only 44% of Americans have saved enough to cover a sudden $1,000 expense without borrowing. Adding to this, inflation is chipping away at their ability to save more out of their regular paychecks.

Navigating life with little to no savings can be a harrowing experience. A car repair, an injury that forces unpaid time off or medical bills for a sick child are common events that would be financially manageable if you had cash to cover them. But if you don't have the funds, they can force you instead to burden yourself with high-interest credit card debt or cut back on essential bill payments and other savings goals.

The IRS issued 128 million refunds in 2021 averaging $2,775 per return. Putting your tax refund to work for you—instead of spending it—is a painless way to put a positive spin on your finances. Here are a few options you might want to consider if you're getting a tax refund this year.

Build your emergency savings

Most financial experts recommend keeping 3 to 6 months' worth of income on hand to cover the unexpected. You don't need to worry about making huge amounts of interest on this money. It just needs to be available to you when you need it.

A $2,775 tax refund, for example, could cover 3 months of salary for a family with a $32,940 income. But even if you can't save the entire refund or your refund isn't that large, saving a portion will still help.

The IRS will let you split your refund into as many as three accounts. The tax-processing giant TurboTax suggests setting up at least one savings account that is separate from your normal spending accounts to collect tax return money. Separating your savings makes it less likely that you'll spend the tax return money on unnecessary items.

Pay off high-interest debt

Once you're comfortable with your emergency fund, you might want to consider paying off high-interest debt. Doing so reduces the total amount of money you'll pay back over time. A debt repayment calculator can show you how much you might save, depending on the size of your payment.

Fund your short-term goals

Do you need to save for a down payment on a new house or car? Maybe your child will need braces soon, or you want to enroll in specialized training your colleagues took to get promoted at work. If so, you might decide to use all or a part of your tax refund savings to help you achieve your short- to medium-term goals.

Increase your retirement savings

Once you're fortunate enough to have covered the basics, you may want to consider devoting some of your refund to your retirement.

Retirement accounts are among the most powerful tools available for putting your money to work. For example, a traditional individual retirement account, or IRA, will let your invested savings grow tax deferred until you withdraw it in future years. You may also get a tax deduction in the current year for the amount you contribute, up to certain limits based on your income.

Younger taxpayers in particular can see substantial gains over time. An average $2,775 tax refund invested at age 37 could grow to more than $9,660 by age 62, given an average 5% annual return. A 30-year-old could see the account grow to more than $13,699, given the power of tax-deferred compound returns.

Keep in mind that retirement accounts are generally not the place to store money you'll need in the short term. You may be on the hook for hefty tax penalties on most types of accounts if you withdraw your contributions before age 59 1/2.

The bottom line

Given the peace of mind and potentially powerful growth that can come from amassing a solid nest egg or two, you're wise to consider saving your tax refund for the future. But before you save—or spend—your lump sum for the long term, it's a good idea to talk with your banker and a tax specialist to weigh your options.