How to Use Your Tax Refund Wisely

Please note that both state and federal tax return filing deadlines have been extended from April 18, 2023 to Oct. 16, 2023 for many California residents. Be certain to verify your tax deadlines on the official sites of the Internal Revenue Service (IRS) and the California Franchise Tax Board (FTB).

While receiving a windfall of cash from a tax refund can feel great, it may be a signal that you need to review your financial plan.

Receiving a tax refund means you have had too much withheld from your paycheck throughout the year, or if you're self-employed, you have overpaid your estimated taxes. In effect, this means that you have made an interest-free loan to the IRS when you could have put that money to better use. You may want to consider adjusting the amount of tax you withhold from your paycheck.

That being said, if you do receive a tax refund, below are several suggestions for how to use the money received wisely. 


Use Your Tax Refund for Your Emergency Fund

The most prudent use of your tax refund is to save it in order to build up your emergency fund. Many people overlook or put off putting funds aside for a rainy day.

If you don't have an emergency fund at all, or an account set up to hold those funds, your tax refund gives you the chance to start one. If you have one already, make sure you know how much should be in it and that it's fully funded. Most planners suggest setting funds aside that can cover three to six months of your annual spending needs.

Budgeting software tools such as YouNeedABudget and Mint can help you evaluate your budget needs and finances and help you put aside and save the right amount for your emergency fund.


Pay Down Your Debt With Your Tax Refund

If you conclude that your emergency fund is solidly in place, you may wish to consider using your tax refund to pay down debt.

Please note that it is important to keep in mind that carrying a balance on credit cards beyond the month charges were incurred will likely cause you to accrue ongoing compounding interest based on each credit card's interest rate (anywhere between 7.9%-17.9%, with some cards charging even higher interest rates).

Personal debt and car loans also may have higher interest rates. Use of your tax refund to lower or pay off credit card debt can help minimize the unnecessary interest payments. If possible, it is strongly suggested to fully pay off your credit cards as bills come in.


Using Your Tax Refund for Retirement

Depending on your income and whether you're covered by a retirement plan at work, you may want to contribute your refund to an IRA or a Roth IRA.

Both traditional IRAs and Roth IRAs permit contributions of up to $6,000 per year, with an additional $1,000 per year allowed as a catch-up contribution if you're over the age of 50.

Traditional IRA accounts may be funded with pre-tax or after-tax contributions, but Roth IRAs may only be funded with after-tax contributions. Once you reach certain income thresholds, only after-tax contributions are permitted for IRAs. Also, once you hit a certain income threshold, you are not permitted to contribute directly to a Roth IRA.

For example, if you are a single person earning less than $68,000 in 2022, you may make deductible contributions to a Traditional IRA, but will not be able to deduct your contributions if you make more than $78,000. For married couples, the deduction phase-out is between $204,000 and $214,000 in combined income.

If your income does not allow you to deduct your traditional IRA contributions, you may consider establishing and contributing to a Roth IRA, depending on your income level. You may contribute directly to a Roth IRA if you make less than $129,000 as a single individual but may no longer contribute if you make more than $144,000. For married couples, that contribution phase-out is between $204,000 and $214,000 of income.

There is no income limit for making your maximum, non-deductible contribution ($6,000 or $7,000 if you're over 50) to a traditional IRA, then converting to a Roth IRA. Over 20 years, depending on performance, your account could be worth over $150,000, and all distributions (over age 59½) taken from your Roth IRA would be received income tax-free.

It's important to work closely with your wealth planner, investment specialist and tax advisor to be sure you're following all IRS rules for IRA and Roth IRA accounts.


Contribute to a College Fund

If you've taken care of your own emergency fund, debt reduction and retirement needs, you might consider using your tax refund to contribute to your children or grandchildren's 529 education savings plan.

When it comes to gifting money to your descendants, you can gift up to the 2022 gift tax exclusion of $16,000 per child per year, or $32,000 per child for a married couple.

Both 529 savings plans and prepaid tuition plans are available, depending on the state you live in. While contributions to these plans aren't deductible on your federal income taxes, some states offer a tax deduction for college savings plans established in those states by residents of those states.

The income earned from the investment is not taxable as long as the funds are eventually used for education purposes, i.e to pay for tuition, room and board, books and supplies, etc. At present, you can use up to $10,000 of the 529 fund per year for tuition and fees at an independent elementary or secondary school.


Get in Touch With a Wealth Planner Today

Depending on your ability to control your spending habits and save money, in the bigger financial picture sense, you may wish to consider focusing on accurately estimating your federal income tax bill so as to minimize your refund. However, if you do receive a refund, you may want to schedule a meeting with your investment advisorwealth planner and tax advisor to see how to maximize its benefits.

This article is for general information and education only. It is provided as a courtesy to the clients and friends of City National Bank (City National). City National does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors or persons quoted as of the date of the article with no obligation to update or notify of inaccuracy or change. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.

City National, its managed affiliates and subsidiaries, as a matter of policy, do not give tax, accounting, regulatory or legal advice. Rules in the areas of law, tax, and accounting are subject to change and open to varying interpretations. You should consult with your other advisors on the tax, accounting and legal implications of actions you may take based on any strategies presented, taking into account your own particular circumstances.