While receiving a windfall of cash from a tax refund can feel great, it could be a sign that your financial planning needs rethinking.
“If you're habitually getting a tax refund, it's important to note how that hurts your cash flow all year," explained Paul DeLauro, manager of wealth planning at City National Bank. "You're giving an interest-free loan to the federal government, which is not something the government gives to you."
But adjusting your tax withholdings takes planning. If you do receive a tax refund in 2021, DeLauro has several recommendations for how to use the extra money wisely.
The most prudent use of your refund is to save it in order to build up your emergency fund, said DeLauro.
If you don't have an emergency fund at all, your 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.
If your emergency fund is solidly in place, DeLauro recommended paying down debt.
“Go after the low-hanging fruit and get rid of as much 'ball-and-chain debt,' such as credit card debt, a personal loan or a car payment, as you can," said DeLauro. “Don't worry about 'investment debt,' such as a mortgage. Just eliminate your other debt to free up money for saving and investing."
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 50. Whereas traditional IRA accounts may be funded with pre-tax or after-tax contributions, Roth IRAs may only be funded with after-tax contributions.
Once you reach certain modified adjusted gross income thresholds, only after-tax contributions are permitted for IRAs. And once you hit that income threshold, you are not permitted to contribute directly to a Roth IRA.
“If you earn $208,000 or less and are married, you can make a traditional IRA contribution with your tax refund even if one spouse is covered by a retirement plan at work," said DeLauro. “If your combined income is above $208,000, then you can't make a direct contribution to a Roth IRA."
However, DeLauro explained there are other options to fund a Roth IRA, including doing a conversion.
“You can fully fund your traditional IRA with after-tax contributions and then convert those contributions to a Roth IRA," said DeLauro. “Over a 20-year period, you could fund more than $100,000 in a Roth IRA via this conversion technique, all with after-tax dollars growing and being distributed tax-free."
It's important to work closely with your wealth advisor and tax advisor to be sure you're following all IRS rules for IRA and Roth IRA accounts, said DeLauro.
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 college education plan.
When it comes to gifting money to your descendants, you can gift up to the 2021 gift tax exclusion of $15,000 per child per year or $30,000 per child for a married couple.
Both college savings plans and prepaid tuition plans are available. While contributions to these plans aren't deductible on your federal income taxes, some states offer a tax deduction for their plans.
The income earned from the investment is not taxable as long as the funds are eventually used for higher education. In addition, you can use up to $10,000 of the 529 fund per year for tuition and fees at an independent elementary or secondary school.
However, in the bigger financial planning sense, DeLauro believes people should focus on accurately estimating their federal income tax bill so as not to get a refund at all.
“Really, the bottom line is this: Do your best not to get a tax refund," said DeLauro. “There's no reason to let the government use your money all year when you could be improving your cash flow with it."
Like what you see? You are invited to keep up-to-date with the latest economic perspectives and shifting global markets by signing up for City National Bank's newsletters here. Delivered biweekly, straight to your inbox.
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.