Ah, it’s springtime. The feet-high snow has melted; and the tree pollens are starting to tickle people’s noses. Another sign of spring: tax fund money is trickling out of Uncle Sam’s fat wallet back into we commoners’ pockets. The average federal tax refund, according to Money magazine, amounts to around $2,700 last year. For many, this is probably the largest chunk of dough outside of their paycheck that they will get their hands on all year. With the economic stimulus and other credit programs enacted by the Obama administration last year, this chunk is expected to get even bigger.
If you are one of the lucky who gets to receive a sizable refund, after congratulating yourself, you will ponder what to do with it. Gone are the days when people take this opportunity to indulge themselves with hot vacations, cool gadgets or shiny new cars. The past year’s economic and financial turmoil has brought no small degree of frugality back in this society; and people are clearly and rightfully more cautious with what they have.
So it all comes down to this good old question: what to do when you get a nice tax refund from the IRS? Here are a few pointers:
Adjust your W-4 form. Everyone seems to have some good ideas about how to spend their tax refund, and what to do first will vary among individuals. However, I believe the first thing you should do when you receive, or expect to get a significant amount of refund is not what to do with it, but to figure out why you would have to get a big refund in the first place. All things being equal, chances are that you had claimed too few exemptions and therefore let the IRS withhold too much from your payroll. Uncle Sam has gotten a free loan here. To correct this, contact your payroll department and ask to file a new W-4 form. Not sure about how much withholding is appropriate? Go to IRS.gov and use the withholding calculator to get specific instructions for filling out new W-4’s. You should see an increase in your take-home money soon after your payroll department makes the adjustment. It’s like getting a raise. Who wouldn’t like to have a little more money tucked in the wallet these days?
Pay off as much high-interest debt as possible. Of course you are not going to fret over getting a big refund, despite knowing that Uncle Sam had taken you for a free ride. Now it’s time to take care of yourself and get some burden off your back. Having a debt balance is like helping someone else to make millions with no returns for yourself. The 18 to 20 percent interest rates that credit card companies typically charge on balances are especially raw deals. To make this matter worse, many credit card companies have boosted interest rates in anticipation of the new credit card law; so carrying a balance now costs you even more. Pay it off, or at least pare it down first. Then take a good look at your mortgage, and if you can put the money toward the principal and not the interest for greater savings. Pay off a balance with an 18 percent interest rate is just like earning 18 percent on your money. Now this is an incredible Warren Buffet – class investment return with zero risk.
Build or rebuild your emergency fund. If the turbulent experience in the past couple of years had taught us anything, that would be the importance of having an emergency fund to fall back on. People lost jobs overnight; 401k’s became 101K’s; and college tuition bills were on the way. Keeping three to six months’ worth of expected expenses squirreled away in highly secure places could ease the pain. The money you put in the emergency fund must be very liquid; and the investment must be nearly risk-free. That leaves you not many choices but to stick with boring vehicles such as insured savings accounts, short-term CD’s, or high-quality money market funds. They pay puny yields – from no more than 2% (short-term CD’s) to almost nothing (savings accounts), but at least can help you sleep well at night. Remember, this is an emergency fund, which will provide you with some legroom and cushion if another crash is heading your way.
Boost your retirement savings. The meltdown of the financial market place has scared away many; you shouldn’t be one of them. In fact, with the markets having been way down and still in recovery mode, this is a good time to participate in the rally. Assuming that you have stopped giving Uncle Sam a free ride, made a serious dent in your debt, and built up a comfortable emergency fund, why not add more nest eggs for your golden years? For 2009, you have until April 15, 2010 to contribute up to $5,000 to an IRA (or $6,000 if you are age 50 and over). You can even contribute to a Roth IRA if your modified adjusted gross income is no more than $120,000 (for single tax filers) or $176,000 (for married couples filing jointly). You can only invest after-tax money in a Roth IRA, but its tax-free withdrawal feature makes it my favorite retirement savings vehicle outside of 401K.
Establish or improve college savings. Have had all the above bases covered? Kudos to you! Now maybe you’ll be able to lend a helping hand for your children’s future. Most people will cringe when they think about the ever-rising costs of putting their kids through college. So start savings early, and take advantage of a couple of excellent investment vehicles where your money can grow tax-free. Right now, you can contribute up to $2,000 a year to a Coverdell Education Savings Account. But I prefer the larger and more flexible 529 plans, which are now offered by every single state. You may cross state lines to find a 529 plan and put in over $300,000 per beneficiary. You can use the money at least federal tax-free for college tuitions and related costs. The website http://www.savingforcollege.com has a full alley of useful information on college savings.
There is a lot more to do when you receive a nice chunk of tax refund money. Since every penny counts, make sure every penny is counted for.