It’s May, which means that many people who filed their tax refund on or right before the April 15th deadline will be receiving refund checks. The average tax refund in 2008 was around $2,700. This means that many taxpayers are over-paying their taxes by a significant amount. Some people think of a tax refund as a “gift” from the government and spend it on something frivolous.
Want to use your refund wisely? Below are four “not so frivolous” suggestions for your tax refund:
First, pay off high interest credit cards. These are the greatest threat to your financial well-being. If you are like the average consumer, you probably have a number of creditors. Pick the debt with the highest interest rate and use your tax refund to pay it off. For an estimate of the repayment time and interest that can be saved by using cash windfalls, such as a tax refund, to repay debt, see Utah State University Extension’s PowerPay Web site at www.powerpay.org.
Second, create an emergency fund. There are several theories on how much you need in an emergency account. If your job is one where you might expect layoffs or downsizing, then you need to have more set aside. Think about how long it will take you to find a new job. How long could you survive financially on your current savings? Having from 3 to 6 months’ living expenses in savings is a good idea. Your tax return will get you there faster.
Third, invest for retirement. That $2,700 average refund is slightly more than half of the $5,000 contribution limit for an IRA for the year 2010 (workers age 50 or over by year-end can contribute an extra $1,000 for a total of $6,000). That $5,000 per year is your ticket to a million dollars if you start early enough. If you’re 25 and you earn an average 8% return, the $200,000 (40 years x $5,000) that you invest will turn into almost $1.3 million for your retirement. For additional information about specific ways to invest your tax refund, explore the eXtension home study course, Investing For Your Future, at http://www.extension.org/pages/Investing_for_Your_Future.
Fourth, adjust your tax withholding so you won’t get a large refund again next year. “What,” you say, “give up my tax refund?” In essence, when you get a tax refund, you have loaned money to the government without interest. Instead, adjust your W-4 with your employer for the best fit in terms of withholding allowances. You probably would not even think of lending money to an acquaintance without demanding some interest as compensation. Why should your tax withholding be any different?
Tax refunds can be a wonderful financial windfall. Unfortunately, too many people receive substantially less than they are due because they take out expensive loans to get an instant refund. Refund anticipation loans (RALs) are high-cost, short-term loans secured by a taxpayer’s expected tax refund.
Studies have shown that many consumers are unaware that RALs are loans, let alone have any knowledge of their high cost. A survey of consumers in Virginia and Arizona found that over 80% of RAL consumers did not realize that they had gotten a loan. RALs generally last about 10 days, which is about the time it takes to receive a refund from an electronically filed tax return. High fees for these short-term loans generally translate into triple digit annualized interest rates.
What if you really need your tax refund money immediately and can’t wait for your refund check? There are several cheaper alternatives to RALs. Other options for quick cash include short-term loans from family or friends, credit union loans, and credit card cash advances. If you e-file your return, you should have your money in 2 weeks or less. File a paper return with direct deposit of your refund to a bank account and the turn-around time is usually less than a month.
