It’s that time of year again; many of us have filed our taxes or are about to do so – and those of us who expect tax refunds are starting to imagine what we might do with ours when it finally arrives.

Save or splurge?

Many people view a tax refund as found money to ‘play’ with, rather than as a means of improving their financial security. If you’re in this group, I challenge you to take a different view this year.

Take a step back and examine the attitude you take toward your tax refund. In many cases we apply to our tax refund the same magical thinking we apply to overeating on a cruise. (“I’m on vacation – these calories don’t count!”) Even those of us who are careful with their finances—and about what we  eat—throughout the year may go a little crazy with this ‘free’ money. Why not treat yourself – hey, it’s only once a year, right?

But the fact is, the very best use for these funds right now is to put them toward your longer-term savings. I know it’s not the “fun” choice – but like many other exercises in delayed gratification, the long term payoff will be well worth it. Think of it as an investment in yourself. Need more motivation? Imagine your hopes and dreams for your future – whatever will make your life feel secure and rewarding and years from now – and remind yourself that you’re working towards those goals.

To make the most of this—and every—year’s tax refund, here’s what I recommend:

  • Add it to your cash reserves to top off your emergency fund. Unexpected expenses happen all the time, but if you have the right cushion of savings, these unexpected expenses don’t have to derail you. Your cash reserves should cover six months’ worth of expenses. After you have this six-month cushion, continue building toward having enough to cover 24 months’ of expenses for longer-term situations such as an extended illness.
  • Start maxing out your company 401(k) or other retirement fund. Don’t just save the minimum in your retirement funds.  Use these funds to get closer to the maximum allowed, so that these funds can grow over time for you.  Your benefits administrator and reputable fund companies like Vanguard and Fidelity can answer any questions you have about how to max out.
  • Start an investment portfolio (if you won’t need these funds for at least five years and after you’ve maxed out contributions to your retirement accounts). Select a low-cost index mutual fund or ETF with one of the high-quality, low-cost players like Vanguard, Fidelity or T. Rowe Price; they will help you choose the right one. You’ll need a minimum of $3,000-$5,000 to start.

The primary advantage of this approach is that it helps people become passionate about saving. Immediately sock away all lump sum amounts—bonus, overtime pay, promotion, tax refund. Doing this—combined with a commitment to saving 10% of your income, no matter how much you earn—results in the confidence of knowing that you’re living within your means. These are the steps that make many other financial accomplishments possible, such as saving the down payment for a house or setting aside a college fund for the kids.

What do you plan to do with your tax refund this year?

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