Using Your Tax Refund to Pay Down Debt

After you file your taxes, you might have another big milestone to check off of your financial “to do” list this year. What milestone am I referring to? Paying off debt!

If you’re due a tax refund, you might be tempted to use the money on a trip or a fun purchase, but the refund could also give you a great opportunity to chip away at your credit card balances or loans. The latter option might not sound very exciting, but it can definitely lead to much more peace of mind.

What is a tax refund?

Some people may be surprised to learn what a tax refund really is: it’s money you overpaid to the government throughout the year. Yes, there are some exceptions, but the main reason you get a tax refund is because too much money was withheld from your paycheck for taxes.

If you’d rather not overpay the government, you can make some changes. Namely, you can work with your employer to reduce your tax withholdings.

However, that’s not the best idea for everyone. The upside is that lower withholdings will give you more money in your pocket from each paycheck — money you can use for things like investing, saving for emergencies or reducing debt. But if you adjust your withholdings too low, you’ll end up owing money to the IRS next year.

As a general guideline, you’ll want to avoid lowering your withholdings unless your refund is large enough that it would have a noticeable impact on your finances if you received it split up over each paycheck, or if your tax situation has changed for some other reason. 

What debt should you pay off with your tax refund?

If your tax refund is enough to pay off all of your debt, congratulations! If not, you’ll need to determine which debt should be paid off first.

The most important factor you need to consider is the interest rates on your accounts. If your rates are high (6% APR and above), the debt should be paid off ASAP, with the highest APR account taking first priority.

Why? Because high-interest debt costs more money than you can earn from putting the funds anywhere else, including if you invest in the stock market.

That means you’ll probably want to prioritize paying off credit cards and personal loans, and any debt with variable interest rates that could increase soon.

But you might hold off on paying down your car loan or mortgage. If you have federal student loans, you may also want to hold off on sending extra payments, since the Department of Education will be your most flexible creditor if you ever need your payments reduced or you qualify for student loan forgiveness in the future.

How can you pay off the remaining debt?

If you have remaining debt with interest rates above 6%, it’s important to figure out how you’ll pay the accounts off as soon as possible. Here are a few debt payoff strategies that can help:

• Debt avalanche method: To save money on interest charges, pay extra money toward your debt with the highest interest rate first. Once it’s paid off, roll the funds toward the account with the next highest rate and continue that pattern until all of your debt is eliminated.
• Debt snowball method: If you’d rather pay off individual accounts faster, use the snowball method by paying extra money toward the account with the highest balance first. Once it’s eliminated, roll your extra funds toward the account with the next highest balance until all of the debt is paid off.
• Debt consolidation: Open up a loan or credit card with lower interest rates, and then use it to pay off your current credit card debt. 
• Debt management plan (DMP): Enroll in a DMP to consolidate all of your credit card payments into one monthly payment, and potentially reduce your interest rates and monthly payment amount.

Not sure which option is best? An NFCC-certified credit counselor can help you decide. Our counselors will review your financial situation, make recommendations about how you can adjust your budget and they can potentially enroll you in a DMP. To learn more, schedule an appointment right away!