Tax season is upon us! And with that, many of us will be getting our tax returns, woohoo!! Time to go splurge at the mall right? Get those new shoes we’ve been eyeing, or maybe a new gaming system? But why not, instead of splurging on short term pleasure (unless it’s something you really need, i.e. your shoes are falling apart), we take a good look at our financial picture to see where that extra money could help out? With an average tax return of $3079 as of February 2023 (1), that could be a big help to a lot of people out there if it’s used correctly! So, what should be done with it instead?
The top three obvious options tend to be the following: build up your emergency fund, get the employer match, and pay off high-interest debt. Now, if you have a lot of obligations, such as children, a mortgage, or other required payments, building out the emergency fund first is probably a smart priority, as you never know what could happen, and it’s more than just yourself to take care of. So if you’re a parent, it might be smartest to build up your emergency fund to an amount that would be sufficient to support the family for three months, and then work on putting enough into the 401k (if your employer offers one) to get the employer match while using any extra money to pay down the highest interest debt you have, such as credit card debt. I’d recommend focusing on those debts that have interest of over 10% as a specific number to use. And then before moving on to any other debts, work to get the emergency fund built up more while also maintaining enough of a 401k deposit to keep the employer match, since that is free money! Ideally, for a parent with children, it might be smart to build up your emergency fund to be able to support your family for a 9 months to a year time frame, depending on your situation and risk tolerance.
Now, if you’re a single person without children, without a mortgage, etc., it might make sense to have a smaller emergency fund while prioritizing maxing your employer match for the 401k and getting rid of high interest debt. With fewer liabilities, making sure to get rid of any interest you’re paying while getting as much free money through the employer 401k as possible might make more sense. But once you take care of the high interest debt, building up your emergency fund to a 6-9 month emergency amount would be ideal with any extra money outside of the 401k amount required for the full employer match.
Now, with the big three of the emergency fund, 401k match, and high-interest debt out of the way, what’s next? With that extra money that you had been using for your high-interest debt and emergency fund, I would recommend trying to max out your Roth IRA contributions. I personally like a Roth IRA over a regular IRA because, once you’re retired, you will not have to pay ANY taxes on the money you pull out. This may not make sense for some people, as it may be better financially for them to pay taxes in retirement, but I just like the idea of knowing that all that money will be mine to do what I want with.
After maxing out that Roth (or regular) IRA, I would recommend trying to pay off debts in the 5-10% range. While the market does average out to return between 8-10% annually, there are down years amidst all of that, so getting rid of debt in that range could help limit your financial liabilities. Now, if instead you wanted to put more money into your 401k or into a normal brokerage, I would completely understand that as well. I just personally would rather get rid of that extra debt to protect myself a bit more.
But how much should I put in? I would recommend having an idea of what your dream retirement amount would be. I personally use https://www.calculator.net/investment-calculator.html to calculate this out. So if you want to end up with a $2 million nest egg for retirement in 30 years, you would need to contribute a shade under $1500 a month to get there. So if you put about $540/month into the Roth IRA (for a $6500 max for the year of 2023 according to the IRS https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits), you would need to contribute roughly another $950 across the 401k and brokerages. However, this will also include your 401k contribution to get the max match, so you’re already likely getting part of that $950. But make sure to play with the numbers, as well as understanding what you’ll need or talking to a financial advisor about what to shoot for for your goals!
Now, there are some other options with that extra money after maxing your Roth IRA. You could look into furthering your education, contributing to an HSA, or even starting your own business! Of course, you could also put money aside for your hobbies, for gift giving, or my favorite, for traveling!
Once you take care of the big three (emergency fund, 401k match, and high-interest debt), you can move to a variety of other options with your money. Whether it be paying off other debts, furthering your investments, having fun, starting a business, etc., taking care of those relieves a great deal of financial stress and sets you up for a healthy financial lifestyle! Of course, even once you accomplish those main three goals, make sure to keep the emergency fund full if you need to take any money out, keep up the 401k contributions, and make sure to stay out of the unhealthy habits that led to the high interest debt!