THE BLOG

Spend Your Tax Refund Wisely

04/09/2014 08:13 pm ET | Updated Jun 09, 2014
Juan Camilo Bernal Photographer via Getty Images

Last year the IRS doled out over 110 million income tax refunds averaging $2,803. Another way to look at it is that collectively, Americans overpaid their taxes by nearly $310 billion in 2012.

Part of that is understandable: If you don't have enough tax withheld throughout the year through payroll deductions or quarterly estimated tax payments, you'll be hit with an underpayment penalty come April 15. But the flip side is that by over-withholding, you're essentially giving the government an interest-free loan throughout the year.

If you ordinarily receive large tax refunds, consider withholding less and instead putting the money to work for you, by either saving or investing a comparable amount throughout the year, or using it to pay down debt. Your goal should be to receive little or no refund.

Ask your employer for a new W-4 form and recalculate your withholding allowance using the IRS' Withholding Calculator. This is also a good idea whenever your pay or family situation changes significantly (e.g., pay increase, marriage, divorce, new child, etc.) IRS Publication 919 can help guide you through the decision-making process.

Meanwhile, if you do get a hefty refund this year, before blowing it all on something you really don't need, consider these options:

Pay down debt. Beefing up credit card and loan payments can significantly lower your long-term interest payments. Suppose you currently pay $120 a month toward a $3,000 credit card balance at 18 percent interest. At that pace it'll take 32 months and $788 in interest to pay it off, assuming no new purchases. By doubling your payment to $240 you'll shave off 18 months and $441 in interest. Use this calculator to try different repayment scenarios.

If you carry balances on multiple cards, always make at least the minimum payments to avoid penalties. Paying down the highest-rate card first will save the most money overall, but some people find that paying off smaller-balanced accounts first is a better motivator.

The same strategy will work when paying down loans (mortgage, auto, personal, etc.) Ask the lender to apply your extra payment to the loan principal amount, which will shorten the payoff time and reduce the amount of overall interest paid. Just make sure to ask whether there's a prepayment penalty before trying this strategy.

Boost your emergency fund. As protection against a job loss, medical emergency or other financial crisis, try to set aside enough cash to cover six to nine months of living expenses. Seed the account with part of your refund and then set up monthly automatic deductions from your paycheck or checking account going forward.

Increase retirement savings. If your debt and emergency savings are under control, add to your IRA or 401(k) accounts, especially if your employer matches contributions; remember, a 50 percent match corresponds to a 50 percent rate of return -- something you're not likely to find anywhere else.

Finance education. Enroll in college courses or vocational training to gain additional skills in case you lose your job or want to change careers. And ask whether your employer will help pay for job-related education.

You can also set money aside for your children's or grandchildren's education by contributing to a 529 Qualified State Tuition Plan. As an incentive, the government allows your contributions to grow tax-free until they're withdrawn. Read the U.S. Securities and Exchange Commission's Introduction to 529 Plans for details.

Spend money to save money. Replace your older refrigerator, washer/dryer or dishwasher with energy-efficient models that will pay for themselves through lower utility bills. The government's Energy Star website can help you find Energy Star products. Other tips:

  • Sell older appliances or donate them to a charitable organization for the tax write-off to help offset the cost of newer models.
  • Switch from traditional light bulbs to energy-efficient alternatives like CFLs and LEDs. Although initially more expensive, they'll save about $6 per bulb in annual energy costs. Just make sure to buy Energy Star-qualified models, which exceed minimum standards. Click HERE to learn more.
  • Ask whether your utility company offers free or subsidized home energy audits. An audit will tell you which investments -- such as increasing home insulation and replacing drafty windows and doors -- will lower both winter and summer energy bills.
  • Schedule routine car maintenance. According to AAA, simply changing your car's air filter once a year can save over $270, while replacing older spark plugs can save $540 in wasted fuel.

Vacation fund. Start budgeting and saving now for your summer vacation so you're not caught off guard when the bills start rolling in. See my previous blog, Avoid Hidden Flight, Hotel Fees, for travel budgeting tips.

Prepay bills. If you expect major expenses later this year (e.g., insurance premiums, orthodontia, college tuition), start setting money aside now so you won't rack up interest charges.

And finally, to check on the status of your refund, go to the IRS's Where's My Refund site. You can usually get information about your refund 24 hours after the IRS acknowledges receipt of your e-filed return or about four weeks after filing a paper return.

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

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