How to use your tax refund wisely

In the article below, we explain why tax refunds arise and some ideas on what to do with the cash.

Why am I owed a tax refund?

Tax refunds occur for a range of reasons. If you've changed jobs or been promoted, you could be on the wrong tax code. Often, new starters are put on an emergency tax code, meaning a basic rate taxpayer has 20% tax applied to their entire salary with no deductions made for their personal allowance.

In some instances, your current or previous employer could simply have made a mistake when processing payroll.

If you haven't paid the right amount of tax, HM Revenue and Customs (HMRC) will post you a tax calculation which will explain how to claim the refund.

Is it free money?

A tax refund might seem like a windfall from the tax man, but it's worth bearing in mind you're not actually getting any money for free.

You are simply receiving the money back that you overpaid – money that you could have been using to pay off debts or save for your future.

What should I do with the refund? It's a good idea to think carefully about what to do with your refunded money. These are some questions to help you to decide:

Do you have high interest rate debt?

A tax refund can be a huge help in paying off any high interest rate debts you owe.

High interest rate debt is likely to far outweigh any interest you're earning on your savings.

If you've got £1,000 in credit card debts and the interest rate is 16%, it is costing you £160 a year. Conversely, £1,000 in a savings account with a 1.5% rate is only earning you interest of £15 a year. Pay off the debt and you'll be £145 a year better off.

Even if you can't afford to pay off your debt in full with your refund, you might be able to make a lump sum repayment that helps you towards being debt-free faster. Make sure you check whether lump-sum repayments or paying off debt early will incur a fee – some loan providers will charge you for early repayment. If this is the case, then you could put the cash in savings until the penalty reduces sufficiently.

Do you have any short-term expenses?

If your boiler is acting up or you think your car will need repairs soon, a tax rebate could help you to foot the bill. This will avoid you having to make cutbacks or borrow money when the need arises.

Even if you don't have immediate expenditure needs, it's a good idea to have an emergency fund to pay for unexpected expenses.

Are you saving for your future?

A tax refund is a great excuse to check whether you're on track to reach your financial goals.

If you're saving up for a house deposit, you could put your tax refund towards it.

You could also look at whether you're saving enough for your retirement. Money paid into a pension attracts a 25% bonus from the government, making it an extremely tax-efficient way of preparing for life after working. And unlike a new car, which drops in value over time, investments can rise in value over the long -term.

What now?

What you do with your tax rebate is a completely personal decision, but it's wise to put some time and thought into it. Remember, it's your hard-earned money and not a gift from the tax man.

These links provide further information:
Claiming a tax refund: https://www.gov.uk/claim-tax-refund
Pensions: https://www.citizensadvice.org.uk/debt-and-money/pensions/