The Internal Revenue Service estimates that around seven out of every 10 tax filers will get a federal tax refund this year, and that the refund will average nearly $2,000.
While the temptation may be great to spend it all, financial advisers say there are many alternative uses that will provide longer-term financial rewards. For example, it presents a golden opportunity to pay down debt or to increase savings. Indeed, one of the most profitable things people can do with their refunds is to pay down credit card debt much, if not all, of which gives rise to nondeductible finance charges. For example, if you pay $2,000 on a card that charges 15% interest, you will save $300 in interest this year that likely produces no tax benefit.
A second possibility is to start building up an emergency fund which most experts say should be large enough to cover at least three to six months of living expenses in the event of job loss (a very real possibility in today's marketplace) or face medical or other unforeseen setbacks. If the money is saved, you would certainly want to consider higher yield money market accounts rather than very low interest bank savings accounts.
Another strong recommendation is to invest tax refunds for retirement, such as an IRA. Employees who don't have retirement plans at work can invest up to $3,000 a year in traditional IRAs. Those with 401(k) and other employer-sponsored plans can look at supplementing them with Roth IRAs. Beginning in 2002, people age 50 and older can put in an additional $500 under a special "catch-up" provision. IRA accounts can be set up with banks and savings institutions as well as with brokerage houses.
While many people perceive a refund as finding money in the gutter, this is not necessarily prudent thinking. One should consider changing that mindset to one of "it's my money and I have allowed the government to use it as an interest-free loan". As a rule of thumb I tell my clients that coming out no greater than plus or minus $1,000 to $1,500 on their taxes is a reasonable tolerance level. If they get back more than that, they should have had the money for themselves during the year. If they owe more than that, they increase the chances of penalties applying and/or having to come up with possibly significant money in a short period of time. To avoid a large refund next year, ask your employer for a new W-4 form and increase the number of exemptions you claim. Of course, the opposite is true if you ended up owing a lot of taxes this year, in which case you might consider revising your W-4 form to decrease exemptions.
As always, I would welcome the opportunity to review your situation with the goal of optimizing your final tax results.
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