There are many decisions in personal finance and money that whatever choice you make is going to be a benefit to your financial situation. For example, paying off your mortgage early or investing are both benefits to your financial situation. The goal with your tax refund is to put yourself in that same situation where each choice is a benefit. So let’s answer the question: “What should I do with my tax refund?”
What Should I do with my Tax Refund?!?!
The first thing I ask myself and also my clients is what did I do with my tax return last year? Philosopher George Santayana once said, “Those who cannot remember the past are condemned to repeat it”.
This especially relates to those who think back and realize they spent the money on a new TV, clothes, or anything really that did not have a positive long term effect on your financial health. That was last year though, this is the new and improved you.
If you are reading this post you are thinking and planning your next steps. You are changing for the better. Congratulations!!!
Are you thinking about paying off debt? Saving for a vacation? Investing? All of these are great uses of your tax refund. Here’s what I do and recommend to my clients.
Pareto Principal aka 80/20 Rule
The Pareto principle (also known as the 80/20 rule, the law of the vital few, or the principle of factor sparsity)states that, for many events, roughly 80% of the effects come from 20% of the causes.
How do I apply this to my tax refund?
Many of us know the right thing to do is to apply this towards making our financial road ahead a better one. It’s what I call Brick by Brick, building the road to your financial freedom. We know the right thing to do is pay off debt, increase our emergency fund, save for a vacation in cash, invest for our future. What we do is something else. Right thing vs What We Do
This is why I use 80/20 rule for my tax refund and other large bonus or windfall types of money received. The principle behind this is 20% of the results create 80% of the actual outcome. My thought process behind this is these type of events like a refund or bonus are part of your 20% that creates 80% of your results. Actions like this create your 80%.
I take 80% of the proceeds and apply them to where I am in building my Brick by Brick road to financial freedom. The other 20% is guilt free money, the best of the best spend this on what they value the most. The choice is mine and can be done without worry or hesitation.
Why does this work?
It’s the same reason the Debt Snowball works, money is more than a financial calculation. This is about psychology. If you are adding 80% of your tax refund to your savings account and spending the other 20% on a new watch, the spender and psychological part of you is satisfied. 80% and the “Do the Right Thing” is also satisfied.
Why doesn’t Dave Ramsey, Suze Orman, or David Bach tell me to do this?
Personal finance gurus like the above mentioned have often painted themselves into a corner because they must give advice to everyone and it must be on message. For Dave Ramsey to tell you to spend money on buying that new item rather than paying off debt would go against his message.
While I agree that you should follow the Brick by Brick steps to financial freedom, I know how hard it is to give up 100% of your tax refund to debt, savings, or investing. The 80/20 rule with your tax return is essentially eating all of your vegetables so you can eat ice cream after.
Where do I put my tax refund?
The 80%
I follow the Brick by Brick steps which I created while paying off over $100,000 in personal debt. For those of you familiar with Dave Ramsey, these steps will have some similarities to the “Baby Steps”.
Here they are in bullet format and I have also attached a pdf for your viewing pleasure.
- Write down your Values
- Track your expenses
- Budget
- Create an Emergency Fund
- Invest in Free Money
- Pay off Debt
- Become a Super Saver
- Put your money in what you Value most
Values
It’s important to know and understand your values and what you prioritize as the most important items in your life. Write down 3 things you value most in your life. Examples could include but are not limited to travel, church, fashion, family, adventure, etc.
Track Your Expenses
If you don’t know where you are today, then you will never know which direction to head tomorrow. There is a number of ways to track your expenses here are my top 3 suggestions:
- Current bank, credit union, credit card
- Personal Capital (Signing up via this link is free of charge, but this an affiliate link and Personal Capital may compensate me)
- Mint
Budget
I like to keep things Simple. I like to joke that if I cannot explain my budget or any other part of my process to my own mother than I cannot use or teach it to my clients. The zero-sum budget is as simple as it gets.
Creating this budget can be done with a piece of paper, excel, or fancy software. Write down your income at the top of the page for the month and then subtract all of your upcoming expenses for the month until you get to exactly $0. Simple as that.
Emergency Fund
The biggest issue as it relates to getting your financial house on track is unexpected expenses. Now that you have a general sense of how much money is being spent each month by tracking your expenses and creating a budget, the next step is an emergency fund.
The emergency fund should not be a fixed dollar amount pulled from thin air, but instead, this should be the amount that allows you to sleep at night. For some, this number is as little as $500 or $1000 and for others, this number is as high as 6 to even 12 months of their expenses. The more comfortable you are with your budget the more precise this number is.
There are a number of factors that should be considered when deciding if your emergency fund helps you sleep at night. I would focus on 3 main items as shown below when making this decision.
- Job
- Expenses & Expense History
- Family
Invest in Free Money
This brick will only apply if you receive a company match from your employer. After you have laid out the previous bricks on your road to financial freedom make sure to check with your employer to get the company match. Most companies will have some sort of company match between 3%-6% of your salary that you contribute.
This goes against the Baby Steps, but this road is built Brick by Brick, don’t miss out on receiving a 50% return. This will also be a great introduction into saving for retirement and when you become a super saver.
Pay off Debt
Focus, Focus, Focus. When paying off debt you will read about interest rates, snowball, avalanche, side hustles, lowering your expenses, increasing your income, and just about everything you can imagine.
The number one method to pay off debt and pay off debt fast is making debt your ultimate focus. You can’t multi-task paying off debt and do it fast.
Are you currently saving a little here, paying off some debt over there, and saving a little money here and there? NO, focus, focus, focus on paying off debt. The only exception to this is investing in your company match because if you can’t pay off debt with 97% of your income pre-tax then there are bigger issues.
Become a Super Saver
If it’s one thing I hear from friends, family, and clients are the desires to retire comfortably. Most of my friends are in their 30’s and understand that working till later than 65 is a scary action plan. They don’t necessarily need to retire early, play golf every day, or take out their yacht for a European vacation, but the option to not work when they are older is the retire comfortable option they desire.
The action plan for this is to become a Super Saver a term coined by Fidelity. The definition is based on saving 15 percent of your income for retirement, this number also includes a company match in the percentage if available.
For a number of reasons like inflation, longer life expectancy, and the desire to retire comfortably, this is where I work with my clients to start not to finish.
How is it possible to save this much?
Imagine you have no debt besides your mortgage and an emergency fund that allows you to sleep at night, this is the exact goal with my clients. Contributing 15 percent of your income is easily attainable after you have gone through brick by brick to lay your road to financial freedom.
Many of my clients have done very little to this point in retirement savings and why I emphasize becoming a Double Super Saver. The goal is to save 30% of their income. The reality is if you are 35 years old with very little to $0 in savings for retirement, time is no longer on your side to retire comfortably. If you want to retire at 60 years of age, you have only 25 years left.
With 25 years left until retirement, it’s almost imperative to be a Double Super Saver. In the Shockingly Simple Math to Early Retirement, Pete Adney aka Mr. Money Mustache provides a savings rate chart that shows if you save 30% of your income, this will allow you to retire in 28 years. In this scenario, you would be 63 years of age and no longer need to work.
All of these figures and scenarios I mention are “ballpark” answers. Personal finance is personal and each situation will vary. If I can coach my clients to save 30% of their income, I’ll leave the details to a licensed professional later in their journey. One could make a pretty good argument to listen to Warren Buffet and invest 90% in a low-cost S&P 500 index fund and 10% in short term government bonds.
Put your money in what you Value most
The first brick on our road to financial freedom was to write down the 3 things you value most in your life. This was originally done to make sure your spending was matched to what you value the most in your life today. It’s also important to realize why you are doing all of this.
Why am I even paying off debt could be a question you ask yourselves after you see a friend or family member buy a new Ford F-150. It’s easy to get off track if you don’t have a clear picture of what’s important to you.
I clearly know my values are my family, specifically my wife, travel, and health & fitness. For example, as a family, we prioritize trips and vacations with each other when we are spending money. Eating organic food, grass fed beef, fresh vegetables, and working out at my local Crossfit gym are far and above more valuable than buying a new vehicle, in fact, it’s not even close.
These same values apply to the rest of your life and your money. It’s more important to put your money where it brings the most value. Also, I use the term value a great deal, but it’s just as easy to replace value with the word “Happy”. Ask yourself “What makes you happy?”
SAVE MONEY, PAY OFF YOUR HOUSE, KIDS COLLEGE FUND, GIVE TO CHARITY
What’s great about building your road to financial freedom really is the last brick. This allows you to save money for that family vacation, new truck, or whatever adds value and brings happiness into your life.
If creating financial peace of mind for your family is important to you then paying off your house a few years early will bring a TON of value and happiness to your life.
Maybe like myself you came out of college and had entirely too much student loan debt and want to make a wrong a right, creating a college fund for your children could bring value and happiness. We all want a better life for our children and maybe this is your top value.
The possibilities, values, and what makes you happy could lead to donating money at your local animal shelter, giving a homeless veteran a warm bed and a meal, or whatever cause you choose, it’s all up to you.
The 20%
If you have gone through and read every Brick in your road to financial freedom then you probably have already guessed what to do with the other 20%. If like me you often skim the articles here’s the short answer.
Spend the 20% on something you value that you might not have otherwise purchased.
I recently took the 20% and bought a couple of fishing/camping/beach chairs for my wife and whomever she takes along on that trip and also purchased a pair of Cubs tickets for my wife and me when they are visiting here in Miami. I have a few more dollars to spend, save, or invest but it will go towards things I value the most.
After reading this article you should have a clear road map for your tax refund. If you are looking for guidance and accountability on what to do next, your next step is my Money Coach page, I look forward to connecting.