Taxes & Estate: Tax Guide
5 Smart Ways to Use That Refund
Updated on January 9, 2008
AMERICAN TAXPAYERS ARE about to come into a bit of money.
While nobody likes filing tax returns, most people are rewarded handsomely for their efforts: About 75% of taxpayers get a refund, according to the Internal Revenue Service. In 2005, the average refund rang in at more than $2,000, a nice chunk of change.
A cash windfall like this, of course, has Americans across the country struggling with tough decisions, like whether they should buy the plasma TV or book that last minute trip to the Caribbean. As tempting as it may be, consumers would be far better off resisting the consumer electronics department's siren song or tidal pull of rum punch on the beach. Here are five better ways to put that money to use.
1. Don't Borrow Against It
OK, before we get into some suggestions on what people should do with their refunds, let's start with one thing they should definitely avoid: the refund-anticipation loan.
Despite numerous warnings by consumer-watchdog groups and reams of bad press, refund-anticipation loans (RALs) -- which allow taxpayers to borrow against their expected refund -- continue to be a popular waste of money. In fact, about one in 10 taxpayers took out a RAL in 2004, according to research from the National Consumer Law Center (NCLC) and the Consumer Federation of America. The appeal of these loans is that they deliver cash in a day or two, via a tax preparer, who's repaid when the real refund arrives.
The problem with these loans is that they don't come cheap, says Chi Chi Wu, staff attorney at the NCLC. Typically, borrowers pay about $30 to $165 (costs vary, in part, by the loan amount) for what typically turns out to be roughly a 10-day loan. The cost usually includes administrative fees as well as interest charges, which can be downright usurious. The annualized interest rates on these loans can be upward of 700%, says Wu.
That's not the only problem. "If, for some reason, the refund is held up or denied by the IRS, [borrowers are] still on the hook for the [loan]," says Wu. "Folks should know that if something happens, they're liable." And if the loan isn't repaid quickly, late fees are likely to be added.
We implore our readers not to shrink their refunds before they even arrive. For those with a real need for fast cash, a better option is simply to file electronically and have the refund deposited directly into a checking or savings account. Opting for this faster treatment won't cost a dime, and should deliver the refund in about 10 business days, rather than the four to six weeks it takes via snail mail.
It's also worth noting that in addition to the immediate gratification, some folks take out an RAL as a means of paying for their tax preparation, says Wu. The tax preparers encourage this by allowing the taxpayer to deduct the cost of preparation from their RAL. (In other words, the loan includes the cost of the tax preparation, which is then covered when the refund arrives.) But these days, just about anyone can file their tax returns for free online through the IRS Web site
.2. Do Nothing
We know, it's not easy to save money. But the fact is, everyone should have a bit of extra cushion in their budget in case of an unexpected blow, such a job loss, illness or injury.
An emergency fund should consist of three to six months' worth of living expenses held in a cash account like a money-market fund. Unfortunately, with interest rates so low, people earn next to nothing on their money, says certified financial planner Scott Kahan, president of Financial Asset Management. But just knowing it's there can be an enormous comfort when times get tough.
3. Contribute to an IRA
Think about it: If a person invested a refund in a tax-deferred account earning 8% annually, she could double her money in less than 10 years.
And an IRA -- particularly a Roth IRA -- is a great way to do it, says certified public accountant Ed Slott of Rockville Centre, N.Y. With a Roth, there isn't any sort of upfront tax break (like there is with a tax-deductible IRA), but qualified withdrawals taken after age 59 1/2 are completely tax free. "I say, give up the deduction, go for the Roth, and it's all yours for the rest of your life," says Slott. "You don't have to share it with anybody." And remember: There's still time to make a 2007 contribution (the deadline is April 15), as well as one for 2008.
Unfortunately, not everyone qualifies for a Roth. For more on this, click here.
Some folks worry that their money will be locked up until retirement. But it's worth noting that one can always withdraw original contributions at any time without penalty. So if an emergency does arise, the money is available. (In other words, there's no great excuse for not making a contribution today).
For more, see our Retirement section.
4. Pay Off Debt
These days, the average household with at least one credit card is carrying more than $9,200 in credit-card debt, according to CardWeb.com. And consider this chilling statistic: Even if no additional charges are added to that debt, it would take a card holder making just the minimum payments 389 months and $10,505 in interest payments alone to kiss that debt goodbye, according to a CardWeb.com calculator.
Needless to say, tackling high-interest credit-card debt is one of the smartest ways to use a tax refund, says Kahan. After all, doing so provides an immediate return on investment. (And most likely at rates that would be difficult to duplicate in today's stock market.) For more on digging out of debt, visit our Debt Management section.
5. Give It to Junior
If college costs continue to rise at their current pace, four years at a private college 18 years from now could cost more than $320,000. Needless to say, people with kids need to start saving early. Using a refund to contribute to a 529 College Savings Plan or a Coverdell Education Savings Account (CESA) is a great way to do it.
Both of these accounts offer tax-free withdrawals for qualified college costs. With a CESA, annual contributions are limited to $2,000 (per beneficiary), and income limits do apply: Eligibility phases out for those whose AGI is between $190,000 and $220,000 (if married, filing jointly) or $95,000 and $110,000 (if single). The beauty of a CESA, however, is that, like an IRA, the holder can invest funds as he or she sees fit.
A 529 college-savings program, on the other hand, has no income requirements, and parents can contribute up to $250,000 or more per beneficiary (although large contributions could have some gift-tax implications). The potential drawback is that parents are limited to the investment options provided by the plan, which typically total 10 or less. For help with choosing the best 529 college-savings plan, click here.
For more on saving for college, visit our College Planning section.
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