Think carefully before spending tax refund

February 04, 2005|by Lynn Little

A tax refund always is a welcome bonus. Whether it's $300 or $3,000, the way you use that money can have a real impact on your personal and financial well-being.

Plan ahead before spending your refund. Without a plan, you might use the money on the first important thing that comes to mind, and then later realize something else was more important. Planning ahead and involving the family increases the chances you will identify all the possibilities, and think about which are most important.

There are four major uses to consider for your tax refund.

Pay off bills

If you have fallen behind on regular monthly bills, such as utilities or telephone accounts, those should be the first priority. Most other debts should be prioritized with highest-interest rate paid off first.

Suppose you have a credit-card balance of $2,000 at an interest rate of 18 percent, and you're making payments of $50 per month. At that rate it will be 62 months before the bill is paid off, and it will cost you $1,077 interest. If you use your tax refund to pay off $1,000 of that bill, and then continue to pay $50 per month, the bill will be paid off in 24 months, at an interest cost of only $198. You save nearly $800 in interest by paying $1,000 toward the debt now.

Future needs

Establish an emergency fund. Having an emergency fund can get you through small emergencies like car repair or medical bills without breaking a sweat. In the ultimate emergency (loss of income), an emergency fund can keep you afloat until you find another income source. Use part of your tax refund to start or build your emergency fund.

Another use for your tax refund could be to start a special savings fund for those occasional bills that come once a year or every few months. These bills often cause huge problems for families. Avoid those problems of occasional expenses by being ready for the bills. Use your tax refund to start a special savings fund, then keep adding to it throughout the year.

Try long-term savings

You can make progress toward long-term goals, and your tax refund can help make that happen.

Adding just $500 a year into a retirement account such as an IRA can make a difference over a period of decades. Earning an average annual return of 9 percent, a contribution of $500 per year would yield $68,100 after 30 years. Build on the momentum created by that once-a-year contribution, and make a monthly contribution too. If you contribute $500 per year and $25 per month, earning a return of 9 percent, in 30 years you will have $113,800.

Moderate-income workers who contribute to their retirement accounts might qualify for a tax credit. For example, a married couple filing jointly with earnings of $32,000 would qualify for a 20-percent credit. That means that if they contribute $2,000 to retirement accounts, they will receive a direct tax credit of $400. Consult with the IRS for details.

Make special purchases

This could be the time for a new computer. New recliner? Nice vacation? What about that new refrigerator? Or the sofa? These purchases are valuable and some might be essential, while others simply add enjoyment to life.

Your best bet: First put some of your tax refund toward financial security: Then use part of your tax refund to make your day-to-day life better. Among all the items on your "wish list," choose the most important and shop wisely for it.

Spread the wealth

A large tax refund seems like a great idea, but that isn't always true.

You could be investing the money and earning interest throughout the year. You give up that interest income when you let the IRS keep your money for several months.

You could save money on late fees or finance charges if you had the money in your paycheck throughout the year. If you paid a $5 late fee on your utility bill six different times throughout the year, that's $30 you could have saved by getting your tax refund in your paycheck rather than waiting till the end of the year.

If you would like to get your refund money throughout the year instead of waiting, change your Withholding Instructions on Form W-4. If you receive a large refund, it might be because you claim too few exemptions. Talk with your payroll office at work about this.

If you have children and qualify for the Earned Income Credit, you can request to receive part of it throughout the year. Check with the IRS for qualifications and your payroll office for the forms.

Tax refund season is not your only opportunity to make financial progress toward your goals. Every week you have opportunities to improve your financial well-being. If you don't think you can come up with any extra money each month, look again. You might be able to plug a few spending leaks and "find" some money. Once you've found some extra funds, you can use that money to keep bills paid; pay off debt early; build financial security and keep saving - whether you're saving for retirement, college or something else.

Lynn F. Little is a family and consumer sciences educator with Maryland Cooperative Extension in Washington County.

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