Should You Save Your Tax Refund or Use It to Pay Off Debt?

In theory, a tax refund isn't a good thing, as it means you gave the government an interest-free loan and are only getting your money back after the fact. In reality, however, most filers are thrilled to discover that they're due a refund. In fact, many Americans rely on that money to tackle major financial objectives or cover substantial bills.

If you're getting a tax refund this year, you may be inclined to use it responsibly, which could mean boosting your savings or paying down a chunk of your existing debt. The question is: Which takes priority?

What do your savings look like?

To figure out whether your tax refund should go in the bank or toward your debt, you'll need to determine how healthy your savings look. At a minimum, you should have an emergency fund with enough money to cover three months of essential living expenses. If you don't, then padding your savings should absolutely trump paying off debt.

Without adequate savings, you risk racking up more debt the next time an unplanned bill (or series of them) lands in your lap. Therefore, while knocking out some debt is a smart thing to do with a tax refund, your emergency fund should take priority.

If you already have three months of essential living expenses in the bank, then it's a different story. At that point, you might split your refund evenly between paying off debt and boosting your cash reserves. And if you're wondering why, it's because many people need more than three months of living expenses to protect themselves from life's financial unknowns. You never know when you might lose your job and encounter a major home repair simultaneously. If that happens, you might need more than three months' worth of income to get by. Therefore, it pays to push yourself to sock away six months of essential living costs to complete your emergency fund, and your tax refund will no doubt come in handy in reaching that goal.

That said, if you already have six months' worth of living expenses in the bank, you should absolutely feel free to apply your entire refund toward your outstanding debt. Your best bet in this regard is to order your debts in terms of interest rates, and pay those with the highest rates first. Another option is to transfer your various balances onto a single credit card with a 0% introductory rate. Then, use your refund to pay off as much of that single balance as you can.

Did your tax refund cause you to land in debt in the first place?

As long as you're in a good place savings-wise, you should feel perfectly comfortable using your tax refund to knock out the debt you've accrued. At the same time, however, you may want to take a step back and contemplate whether overpaying your taxes during the year caused you to rack up debt in the first place.

Imagine you get $2,400 back from the IRS this season. That means you could've essentially gotten $200 more a month in your paychecks last year. Now think about the debt you racked up in 2018. If you were forced to carry a credit card balance because you were a couple of hundred dollars shy month after month, then you didn't do yourself any favors by letting the IRS hang onto your money for longer.

Therefore, if you receive a substantial refund this season, you might consider adjusting your withholding on your W-4 to claim more allowances and get more money in your paychecks. If you're worried that doing so will cause you to owe the IRS money next year, put that extra money in the bank and only use it when you absolutely have to. This way you might avoid a scenario where you're accumulating debt and getting stuck with costly interest as a result.