The IRS may owe you over $3,000 this year. Here’s how you can use it to build long-term wealth

This year’s average tax refund is $3,324—up 5.7% compared to last year when it was just $3,145, according to the Internal Revenue Service (IRS). This is a welcoming prospect for many Americans who are feeling a financial squeeze due to inflation, debt, and economic uncertainty. Nearly two-thirds of Americans feel like they live paycheck to paycheck, including those who make six figures. 

However, receiving a high tax refund is not necessarily a reason to splurge on a trip to Disney World or a kitchen renovation; in fact, getting a large refund may actually be a bad sign, says Jere Doyle, an estate-planning strategist at BNY Wealth. 

“Using tax refunds as an investment strategy is counterproductive and doesn’t make sense,” Doyle tells Fortune. “A tax refund is, in effect, an interest-free loan to the government. By overpaying your tax liability, you are giving up the use of that money and getting no investment return.”

Ashley Weeks, a wealth strategist at TD Wealth adds that it pains him when clients get excited about a larger-than-expected tax refund since it’s not really ‘free money.’

Going into credit card debt to make up for income withheld by the government can be especially worrisome, Weeks says—but for many Americans, that’s reality. A survey from TaxSlayer finds that over three-quarters of Americans plan to use their refund for necessities, like rent, groceries, and credit card debt. 

Using a tax refund to build long-term wealth

The tax filing process can be stressful, and it drives many Gen Zers in particular to tears. But while getting a refund can feel like a reward and serve as a savings mechanism, the process can be simplified. If you owe or are refunded more than $1,000 during tax season, Weeks suggests revising your W4 on file with your employer and update your withholdings.

“Ideally, tax filing should be a mild annoyance,” he says. “It probably shouldn’t be a really exciting event, like a treasure hunt where you get a big ton of money, and it shouldn’t be a terrifying event where you know you’re expecting to write thousands of dollars and send it to the government with interest in penalties.”

If you find yourself one of the over 100 million individuals or households who will receive a refund, there are several strategies you can use to stretch those dollars and turn them into a long-term strategy.

Set up an emergency fund

Over 1 in 4 Americans do not have a financial safety net, meaning when an unexpected expense arises like needing new car tires or repairing an air conditioner, they are left scrambling. This can sometimes lead to early withdrawals from their 401k, which Weeks says can do “real damage” to one’s long-term financial success.

Starting an emergency fund is thus one of the most important steps one can take in their financial life. Having three to six months of expenses in a readily available account, like a high-yield savings account, is an important consideration, says Roberta Fitzgerald, a financial advisor at Northwestern Mutual.

“Consider this a safety net to help cover unexpected costs like home or car repairs, medical emergencies or even temporary job loss, so that you stay afloat when life throws a curve ball,” she adds.

Get a handle on your debt

After establishing an emergency fund, a tax refund can also be used to make substantial progress toward paying off debt like credit card balances or car loans. Targeting high-interest consumer debt, such as from credit cards or payday loans, should be a high priority, Weeks says.

“Found money is certainly a good opportunity to reduce some of that debt and reduce some of the outflows every month for servicing the interest,” he adds.

Invest for short- and long-term gains

A substantial tax refund can also be a perfect opportunity to invest—and let the money grow, which is a “better use” than spending it on something fun, Doyle says.

For example, a CD can yield 4% to 4.5% in less than a year. But because the gain is taxed as ordinary income, putting money in a mutual fund with a growth objective might be a better choice, Doyle adds, due to lower long-term capital gain tax rates.

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A hypothetical $3,000 investment in a S&P 500 index fund during March of last year would have grown by over $500 by now. And while 2024 had an above-average stock market performance, a yield of just a few hundred dollars can compound into thousands of dollars in the long term. 

“For those with a long-term investment horizon, it makes sense to stay invested. Trying to time the market is not a good idea. There will always be ups and downs in the market. If one cannot tolerate volatility, they might want to consider doing something else with the money like paying down debt,” Doyle says.

A tax refund can also be a great opportunity to bolster contributions to a retirement savings account like a 401k or Roth IRA. However, for those worried about market uncertainty, Andrew Crowell, financial advisor and vice chairman of wealth management at D.A. Davidson, says making an extra payment on a mortgage or student loan can be a wise idea since it can reduce interest payments.

“When it comes to ‘found money’ like a tax refund, investing can be a sound approach to help feather one’s nest egg a bit more—but in uncertain market climates like we’re seeing, other strategies might be even more valuable,” he adds.

Crowell also suggests that investing in yourself can be smart, like taking a class, joining a health club, or starting a new hobby like piano lessons.