4 Better Ways to Spend Your Tax Refund

04/29/2015 08:31 pm ET | Updated Jun 29, 2015

Picture this: You wake up one morning and head outside to get the newspaper.

Sitting there on the stoop is a bag with your name on it. You open it and find a wad of cash -- totaling $3,120!

Your mind starts to race as you think about how you'll spend this money that's fallen into your lap.

Perhaps you'll pay off debt, pad your 401(k), or beef up that down payment fund for a new home. A blowout vacation sounds nice too -- because, hey, how often do you get a windfall like this?

Or maybe you're actually at a total loss for what to do, especially since, unless your name is Tony Soprano, this hypothetical scenario seems rather unlikely.

Well, we've got news for you: In the coming weeks you could be one of the many Americans receiving what the IRS has quoted as the average tax refund of -- you guessed it -- $3,120.

And it's precisely why we thought it was high time to take a look at the common ways people make poor decisions when it comes to tax refunds -- and the better strategies to consider should this bonanza hit your own bank account.

A Little Tax Refund Psychology: How Our Minds Tend to Process Windfalls
Who would have guessed that getting a check from the IRS could elicit feelings of bliss akin to falling in love or landing a coveted promotion?

"We tend to have clear rules for our approach to our paycheck, which arrives on a predictable basis," says financial psychologist Brad Klontz, Ph.D., coauthor of "Mind Over Money." "But we treat a sudden cash infusion, like a tax refund, very differently."

A big refund can make you feel like you've hit the jackpot, bringing about a passionate response. Your amygdala -- the mind's emotional hub -- takes over the prefrontal cortex, or "thinking center" of the brain, which can cause you to act in a rash manner.

Translation: No matter how diligent you usually are, once you have that check in hand, your prudent financial habits can easily get tossed out the window. Before you know it, you've booked an all-inclusive getaway to Fiji.

Luckily, there are some strategies that can help inoculate you against these ill effects.

For starters, "just being aware that we're all prone to impulsive behavior around tax-refund time will activate your prefrontal cortex," Klontz says. "You're now in an analytical frame of mind, where you're curious about understanding your emotional reactions -- instead of being controlled by them."

The next rule is to wait at least 24 hours between receiving your refund and spending it, giving you time to reflect on what move would best align with your long-term goals.

It's also prudent to talk to someone -- your spouse, a parent, a financial planner -- about your spending plans. "Hearing yourself state your intentions out loud can give you the opportunity to cross-check your impulses and get feedback on how reasonable your idea really is," Klontz says.

Finally, remind yourself that even though your refund might feel like "found" money, it isn't. You earned it throughout the year, so you should manage it responsibly, just as you would the rest of your salary.

Think you've got it under control?

Check out the top four ways Americans plan to use their refunds this year, based on a survey by the National Retail Federation -- and see how you stack up.

Refund Move #1: 47 Percent Plan to Stash It Away
So What's Wrong With That? Believe it or not, there's an art to saving well. While it might be tempting to funnel 100 percent of your refund into a single savings account, the reality is that might not be the best approach.

A Better Strategy Assess which savings categories you most need to bulk up. "Write down and prioritize all your goals -- but not necessarily chronologically," says Cheryl Costa, CFP® and principal at Forteris Wealth Management in Boston. "What are you most behind on?"

In terms of urgency, starting an emergency fund should top your list, followed closely by retirement savings. Then, depending on your particulars, setting up a college fund or other focused effort, such as a home down payment.

Contributing to your accounts in this order means you're likely saving smartly -- and not tempted to, say, allocate everything to your vacation fund when you're short on more pressing goals.

Another tip for save-happy refund receivers? Let loose a little. "The downside of being overly vigilant with savings is that you can sacrifice the joy of money by being too anxious about the future -- and therefore unable to enjoy the present," Klontz says.

Severe frugality can easily cross over into self-deprivation -- and that's no way to live.

"So whether it's a massage or a nice dinner out, give yourself permission to splurge a little here and there," Costa says. "At the end of the day, you're still on the right track."

Refund Move #2: 39 Percent Plan to Pay Off Debt
So What's Wrong With That? There's no doubt that eliminating debt is an admirable financial goal but, interestingly, there are a few pitfalls to beware of when earmarking your refund for this reason.

Not all debt is created equal -- meaning it's important to discern that you're paying off accounts in the right order. And, in some cases, tackling certain savings goals should take priority over your quest to become debt-free.

A Better Strategy Before you dedicate your refund to debt repayment, make sure you can check a few other to-dos off your list, starting with your emergency fund.

"Having a safety net set aside is more important than paying off any loans, especially if you're living paycheck to paycheck," Costa says. "If something were to happen or you lost your job, you'd have nothing to fall back on -- and potentially dig yourself even deeper into debt."

Once you've squirreled away one month's worth of take-home pay, you can tackle your savings and debt goals in tandem -- splitting the remainder of your refund between your emergency fund and making a larger credit card or loan payment.

Already finished this to-do? The next step that can help you figure out a better way to spend your refund is to calculate your debt ratio, or the percentage of your income that's allocated to debt payment.

If it's below 36 percent, Costa suggests that upping your retirement contributions to the point of your employer match, if offered, may give you the best bang for your buck. However, if your ratio is dangerously close to or exceeds 36 percent, that means your credit could be in jeopardy, and eradicating debt should indeed be your primary objective.

Just remember to prioritize your loan payments according to which accounts carry the highest interest rates. Paying off a sky-high credit card balance at a 16 percent interest rate is usually much more urgent than dealing with a student loan at 4 percent.

Refund Move #3: 25 Percent Plan to Cover Daily Expenses
So What's Wrong With That? It's a classic expression: Manipulating your W-4 in order to purposely plump up your refund is basically giving Uncle Sam an interest-free loan.

That's not a smart game plan, even if you intend to save your tax-time windfall -- but it's especially worrisome if you truly needed that money throughout the year.

"If you use your tax refund to pay for necessities, then you are doing a disservice to yourself by withholding so much," Costa says. "These dollars should be landing in your pocket every month instead of going to the government."

A Better Strategy March over to your favorite HR person's desk, and ask to fill out another W-4.

"The more exemptions you claim, the less money will be withheld in taxes," explains Costa. "So if you claim only one or two exemptions, and you get a big refund each year, filling out a new W-4 and claiming more exemptions will result in an influx of money in your paycheck each pay period."

While you may automatically default to either 0 or 1 exemption, it's worth taking 10 minutes to read through the detailed form instructions to determine what makes sense for your specific circumstances.

For instance, someone who earns a moderate income but who carries an expensive mortgage in an area with high property taxes could potentially claim 8 to 12 personal exemptions.

"Many people think that their exemptions cannot exceed their family size, but that is most definitely not the case," Costa adds.

The truth is, no matter how much of a pleasure rush you might get from a fat refund check, it actually points to a lack of money savvy.

"You could have been using that cash to slowly build an emergency fund, or work toward another goal -- and gain a little interest on it in the meantime," Costa says.

Refund Move #4: 24 Percent Plan to Splurge
So What's Wrong With That? After working your tail off all year, it's understandable if you'd want to indulge a little -- but the emphasis here needs to be on a little.

Going whole-hog by relinquishing your entire refund to buy plane tickets to Paris or a new iMac can be a bad move for your budget.

A Better Strategy Follow the 90/10 rule, in which you devote 90 percent of your tax refund toward financial goals, like maxing out a Roth IRA, and 10 percent for carefree spending.

"The 90/10 rule is a good one because it's just another way to give yourself incentive to stick with your savings plan," Costa says.

But what if you had your heart set on using your entire refund for a big-ticket purchase -- like a fancy new kitchen -- and 10 percent won't cover it?

"Then the cold, hard fact is you can't afford it," Costa says. "You can try to convince yourself otherwise, but ultimately, it's no different than charging up your credit card."

If there's something you really want or need, the (much!) smarter system is to allocate a certain portion of your monthly income to gradually save up for it.

Figure out how much the item will cost -- after you subtract 10 percent of your refund -- and divide that amount by 52. That number represents the sum you have to put aside each week if you want to reach your goal within a year's time.

Once you've hit your target, feel free to go crazy with that Viking Range.

This post originally appeared on LearnVest.

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LearnVest Planning Services is a registered investment adviser and subsidiary of LearnVest, Inc., that provides financial plans for its clients. Information shown is for illustrative purposes only and is not intended as investment, legal or tax planning advice. Please consult a financial adviser, attorney or tax specialist for advice specific to your financial situation. Unless specifically identified as such, the individuals interviewed or quoted in this piece are neither clients, employees nor affiliates of LearnVest Planning Services, and the views expressed are their own. LearnVest Planning Services and any third parties listed, linked to or otherwise appearing in this message are separate and unaffiliated and are not responsible for each other's products, services or policies.

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