Should You Use Your Tax Refund to Pay Off Debt?

Published February 2021

Boosting savings and paying off debt are two of the most popular uses for Americans’ tax refunds year after year. According to a recent survey, around 31 percent of tax refund recipients expect to drop their windfall into their savings accounts. Twenty-four percent of them plan to put a dent into their debts with the money.


Key Points
  • 31% of tax refund recipients plan to save it.
  • 24% expect to pay off debt with their refund.
  • Assess the health of your emergency fund before deciding what to do with yours.

The majority of Americans adopt a responsible approach to using their tax refund windfall. But some succumb to the temptation to splurge on some retail therapy instead, seeing their refund as free money the Government is generous enough to let them have. 
 

Your 2020 Tax Refund Is Not Free Money

Your 2020 tax refund is the difference between the amount you paid and your real tax liabilities for the year. It is nothing more than an interest-free loan you gave Uncle Sam out of your pocket. If you look at it like that, it is hardly worth celebrating. What is worse is that having overpaid your taxes throughout the year, not having access to this money may have landed you in debt. 

At the very least, you should view your 2020 IRS refund as your money that the Government temporarily held for you. This attitude should define how you decide to invest these funds. 

How to Use Your 2020 Tax Refund Wisely

The question is whether you should sock away your refund as savings or use it to get the debt monkey off your back. Though it would not be a crime to use your refund to finance a trip to an exotic location, it would certainly not help your financial situation to make that choice. 

To determine how to use your 2020 tax refund in the best possible way, take a look at the state of your savings. 

If You Do Not Have an Emergency Fund

If you do not have adequate savings, meaning at least three months’ worth of essential living expenses, you should put your refund money into an emergency fund. Not having an emergency fund means that you could find yourself neck-deep in debt when you have to take care of an unexpected bill. It is not worth exposing yourself to more debt just to cut back on your existing balances. 

Build up your emergency fund first, and then explore other ways of addressing your debt. Contact a ClearOne Certified Debt Specialist at 866-481-1597 to learn about your debt relief options.

Debt settlement is a debt relief method that can shave significant amounts off your principal debt. It can also give your debt repayment efforts a structure and direction and help you get out of debt in as little as 24-60 months. 

If Your Emergency Fund Exists but Is Barely Adequate

If you have three months’ worth of essential living expenses socked away, but not much more, you may want to split your 2020 IRS refund and use half to boost your emergency fund, putting the other half toward debt repayment. 

Although the general rule states that you should have at least three months’ worth of expenses covered, to minimize your exposure to debt, you may want to expand that fund to cover six months’ worth of expenses. 

Through this approach, you would stave off new debt while putting a dent in your existing debts. 

Emergency fund glass jar.

If Your Emergency Fund Is More than Adequate

If your emergency fund is looking great, it makes sense for you to use the entirety of your 2020 IRS refund to get rid of as much debt as you can. Such an approach makes sense for many reasons. 

  • The interest on your debt is probably higher than the interest your savings earn. 
  • Even if you cannot pay off your debts in their entirety, you get to pay them off faster, and thus you save money on the interest you pay. 
  • By eliminating all or some of your debt, you boost your credit score and thus gain access to more attractive financial products. 

(Pro Tip: If your debts do not amount to much and are well under your control, contributing your 2020 tax refund to a retirement account also makes good financial sense. )

Use Your Tax Refund the Smart Way

To recap, take care of your emergency fund first. You have to minimize your exposure to life’s curveballs and the debt they entail. 

Be aware that you always have other options to deal with debt, such as debt consolidation, credit counseling, or debt settlement.  ClearOne Advantage can help you find the debt relief option that works best for your unique situation. Take a moment today to get a free savings estimate.

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Topics: Financial Education