This winter, Americans will file their Income Tax returns and eagerly await their refunds. According to the IRS, the average tax refund is $3,120. Rather than do something “fun” with that money, Americans should use their refunds to save or pay down debt.
The annual personal savings rate in the U.S. is only 6%, which is below the historical average of 8%. Average income after taxes in the United States is $39,371, according to the U.S. Bureau of Economic Analysis. Thus, with a six percent personal savings rate, the median American saves $2,362 per year. If Americans saved their tax refunds, the personal savings rate would more than double. The low personal savings rate is reflected in a Federal Reserve survey which found that 46% of Americans do not have enough cash on hand to meet a $400 emergency need. Financial planners recommend having a nest-egg amount to meet six-to-nine months of expenditures. Saving your tax refund is a good place to start.
Americans do not save enough for retirement. According to the U.S. Government Accountability Office, the average 401(k) balance is $16,000 for a worker in his/her 20s and $172,000 for a worker in his/her 60s and about to retire. While $172,000 may sound like a lot, this would only yield a $950 monthly income for 20 years, assuming the value of the annuity grows at 3% per year throughout retirement. For comparison, a full-time minimum wage earner in Michigan would earn $1,360 per month in income. If a 30-year-old invested his/her tax return in a tax deferred stock account (such as a traditional IRA or 401(k)) and earned a 6.5% annual return, his/her $3,120 tax return would grow to $20,600 in 30 years. If that 30-year-old invested his/her tax return in that stock account every year and earned a 6.5 % annual return, in 30 years, he/she would have over $250,000 in the account. By itself, this would represent a 50% increase in the value of a typical 60-year-old’s 401(k).
Americans also hold a great deal of credit card debt. For households with credit card debt, the average amount is $15,675 at a 15% interest rate, according to the website NerdWallet.com. If the household only makes monthly minimum payments (assumed to be 3% of the balance plus interest), it will take 20 years to pay the credit card off while paying $11,000 in interest. If the household puts its tax refund toward this debt and continues making only the minimum payments, it will pay off the credit card in just under 19 years while paying $8,831 in interest. If the household puts their entire tax refund toward their credit card debt for two consecutive years, plus an extra $520 from a third year’s refund, the credit card will be paid off in 26 months while paying only $2,700 in interest.
Using your tax refund to save or pay off debt might not be much fun, but it yields a huge future benefit.