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Use tax refund to pay off debt

February 02, 2007|by LYNN F. LITTLE

A tax refund is always 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.

It's tempting to think about buying that big screen TV, but a rush to spend your income tax refund can erode the value of the refund. Before you spend your refund, try to think through all your options, even ones that aren't very glamorous. Use the waiting time to plan how you can use your tax refund to improve your financial situation.

Follow three general rules:

1. Do plan ahead before spending your refund. Without a plan, you may use the money on the first important thing that comes to mind and 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. Ask yourself:

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· Do I have outstanding or past due bills?

· Am I carrying a balance on my credit card?

· Can I use the refund to clean up holiday bills? Should I set aside part of it to eliminate holiday bills from December 2006?

· Do I have a big expense, such as property taxes, an insurance premium, loan payment or major car repair coming up?

· Do I have adequate emergency funds set aside?

Consider using your tax refund or a portion of it to pay down debts with the high interest rates. If you owe $2,000 on a credit card charging 18 percent interest and pay $50 a month, it will take five years to eliminate the debt. The total interest you will pay is $1,077 - more than 50 percent of the original debt.

If you have one or two smaller debts, you may get more satisfaction from paying them off in full. This will free up money to increase your monthly payment on the higher interest debt.

Do you have an emergency fund? Three to six months savings is a goal recommended for an emergency fund, but one that may not seem easily attainable. To begin, try to put away $5 or $10 a week to build emergency savings. Use part of your tax refund to build your emergency fund.

Consider using your tax refund or a portion of it to start a special savings fund to help pay those big bills that come once a year or every few months. Avoid problems with those bills by being ready for them. Keep adding to the savings throughout the year.

2. Do devote a portion of your tax refund to build long-term financial security. Contribute to your retirement account or Individual Retirement Account. Adding $500 a year to an IRA can yield $68,100 in 30 years.

3. Don't throw away part of your refund on loan fees. Companies that offer "quick refunds" are just giving you a loan - a high-cost, high-risk loan. If you need quick cash, arranging a short-term loan with a financial service provider usually is less costly than a refund anticipation loan, which typically has a higher interest rate and loan processing fee or fees. A refund anticipation loan requires a taxpayer to pay a hefty interest rate to borrow his or her own money for a relatively short time, sometimes two weeks or less.

Filing early, rather than waiting until a day or two before the annual April 15 deadline, filing electronically and/or opting for direct deposit can minimize the waiting time for a refund.

People sometimes think of a tax refund as forced savings, yet, in reality, you have provided a loan to the government without earning any interest. If your tax refund is substantial, check with the human resources department at your work to adjust your tax withholdings to better match your tax liability.

Still feel the urge to splurge? After paying down debt and adding to savings for short- and long-term goals, set aside a small amount as a reward, something you and your family will enjoy.

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

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