Each spring, millions of Americans look forward to receiving a hefty income tax refund. And it truly is "hefty" with the average federal refund in 2010 hovering around $3,000. That's a lot of money to be giving the government through what is essentially a year-long, interest-free loan.
If you regularly receive large tax refunds, you're probably having too much tax withheld from your paycheck. Instead, you might want to withhold less and put the money to work for you, by either saving or investing a comparable amount each month, or using it to pay down debt. Your goal should be to receive little or no refund at the end of the year.
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.) Just be careful, because if too little is deducted, you might end up owing more tax next April, and possibly even interest or penalty fees. IRS Publication 919 can help guide you through the decision-making process.
Some people received larger-than-normal tax refunds in 2009 and 2010 thanks to the Making Work Pay credit, which expired December 31, 2010. In its place, most taxpayers will see a 2 percent reduction in the amount being withheld for Social Security in 2011 paychecks as part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.
Another change this year was a U.S. Department of Treasury pilot program that offered 600,000 randomly selected low- and moderate-income families an opportunity to have their tax refunds direct- deposited into a MyAccountCard Prepaid Debit Card offered by my employer, Visa and issued through Bonneville Bank. The pilot explored ways to save the government money (a direct deposit costs 1/10th as much to process as a paper check) as well as to give people with no bank account easier and more cost-effective access to their tax refunds.
If you will be receiving a large refund this year, here are ways to put it to good use:
Pay down debt. By increasing your payment amount on outstanding loan or credit card balances you can significantly lower the total amount of interest paid. Say you're paying $80 a month on a $2,000 credit card balance at 18 percent interest. By doubling your payment to $160, you'll reduce the payoff time from 32 months to 14, and shave $295 off the total amount of interest paid. In effect, you'd be getting the equivalent of an 18 percent return on your money.
Start an emergency fund. To protect your family against the impact of a layoff or other unexpected financial crisis (such as a medical emergency, car accident or theft), set aside enough cash to cover at least six months of living expenses.
Save for retirement. If your debt and emergency savings are under control, add to your IRA or 401(k) accounts, particularly if your employer matches contributions; remember, a 50 percent match corresponds to a 50 percent rate of return.
Invest in yourself. Enroll in college courses or vocational training to ensure you have additional skills to fall back on should you lose your job or want to change careers. And ask whether your employer will help pay for job-related education.
Invest in your family's future. Another good use for your refund is to set up a 529 Qualified State Tuition Plan or a Coverdell Education Savings Account to fund your children's or grandchildren's education -- all while ensuring your contributions will grow tax-free until withdrawn. Visit the websites of the U.S. Securities and Exchange Commission's Introduction to 529 Plans and the IRS's Tax Topic 310 - Coverdell Education Savings Accounts for information.
Spend money to save money. If you've got older appliances such as refrigerators, washer/dryers or dishwashers, consider replacing them 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.
And finally, if you want 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 72 hours after the IRS acknowledges receipt of your e-filed return or three to four weeks if you filed 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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