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Big Tax Refunds Can Be Costly

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This is the season for income taxes -- and income tax refunds. According to the IRS, nearly 78 million people received federal tax refunds in 2009 averaging $2,705. If you're one of those folks, it may be tempting to think of your refund as a gift; but in fact, by having too much money deducted from your paycheck, you've essentially been giving the government an interest-free loan for the past year.

Before spending this year's refund, get on the right track for next year. Contact your employer's human resources department and ask to complete a new W-4 form that more accurately reflects how much should be withheld each pay period.

This recalculation is especially important if your income level has increased or decreased significantly or if your family situation changes -- for example, if you've had a new child, reduced the number of dependents you're claiming (whether children or adults), gotten married or divorced, or changed the amount of dependent care expenses for which you plan to claim a tax credit. Your goal should be to receive little or no tax refund next year.

So what should you do with this year's refund? Here are a few suggestions:

Pare down debt. By accelerating your credit card and loan payments, you can significantly lower the amount of interest paid over the long run. For example, suppose your credit card balance is $2,000 at 18 percent interest and you're only paying $80 a month. Even with no further purchases, it will take 32 months and an additional $526 in interest to pay it off; by doubling your payment to $160, you reduce the payoff time to 14 months, and save $295 in interest.

In what's sure to be an eye-opener for many people, as part of the credit card reform laws that took effect February 22, 2010, your monthly credit card statements must now show how long it would take to pay off your bill making only minimum payments.

One caution: Before making extra payments on your mortgage or car loan, make sure there's no prepayment penalty. If there is, see if you can renegotiate the terms; otherwise, pay down other debts first.

Save for emergencies. To protect your family against the impact of a layoff or other unexpected financial crisis (such as a medical emergency, car accident or theft), build up your savings to cover six months of living expenses. It's best to keep emergency savings in liquid accounts like a Money Market account that you can access easily without paying early withdrawal penalties.

Another option is to park that money in a high-yield checking account where, in exchange for certain restrictions (like mandatory direct deposit and a minimum number of monthly debit card transactions), you can earn much higher interest than in a traditional savings or checking account. Numerous websites track high-yield accounts including DepositAccounts.com and CheckingFinder.com. Just be sure to compare terms and restrictions carefully.

Save for retirement. If your debt and emergency savings are under control, consider beefing up your IRA or 401(k) accounts, particularly if your employer matches contributions; a 50 percent match corresponds to a 50 percent rate of return, which is pretty difficult to find, no matter what state the economy is in.

Save on energy, save on taxes. You can claim a tax credit for up to 30 percent of the cost of certain home improvements to existing homes (including central air conditioning, furnaces, windows, insulation and water heaters) purchased by the end of 2010, up to a maximum of $1,500 -- including credits you may have claimed in 2009. Not every product qualifies, so visit the government's Energy Star website for details before you buy. To learn more about the IRS policies and forms for energy efficiency incentives, click HERE.

Bottom line: Before you splurge on something you don't really need, consider investing at least part of your tax refund on something that will boost your future financial security.

This article is intended to provide general information and should not be considered tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how tax laws apply to your situation and about your individual financial situation.

Follow Jason Alderman on Twitter: http://twitter.com/PracticalMoney