The arrival of springtime means it’s tax season. For anyone lucky enough to receive a tax-refund check this year, it’s a time to dream of splurging on a vacation to a tropical paradise or buying a new set of wheels to replace the old clunker.
Most folks, however, can’t afford to get too self-indulgent when it comes to using their tax refund. For many consumers, there are bills to pay, college tuition to save for and credit-card debt to pay down. And refunds are coming due for many Americans—the IRS says the average refund is $3,120, and more than 80 percent of taxpayers receive a refund.
For taxpayers who have more financial resources, the calculations and advice is different and can involve more detailed planning, says Agnes Lew, who heads up wealth management at East West Bank.
“We want to make sure that people can maintain their lifestyle during retirement,” Lew says. “People are living longer. Instead of saving for 10 years of retirement, these days we can easily live to 90 or 100. Clients may be better off investing their refund check in their business.”
An investment in a business could net an owner returns of 30 percent a year, she says.
"An investment in a business could net an owner returns of 30 percent a year."
For many people, the best use of refund money is to set up an emergency fund.
“Very few Americans have an adequate emergency fund,” writes Trent Hamm, editor of The Simple Dollar, a consumer advice website. Such a fund “is a savings account somewhere that contains money that could be used for living expenses for several months in the event of a major crisis, like job loss.”
The best place for stashing an emergency fund is a money-market account or a savings account that earns interest, Lew says.
For anyone who has a pile of credit card debt that carries high interest rates, it’s high time to pay down that anvil weighed around your neck, says the National Foundation for Credit Counseling, a Washington D.C-based nonprofit that provides financial assistance to consumers. It’s almost always a smart idea to use tax refund checks to pay off at least some of your credit card debt.
“Use your refund to pay more than the monthly minimum payments,” the NFCC says. If you can’t pay them off completely, make an extra payment. By making an extra credit card payment you can reduce your interest costs.
"If your debt is a tax-deductible mortgage at 3 percent, then saving for retirement could be a better option."
The prospect of tackling credit card debt doesn’t have to be all pain and agony. The American Institute of CPAs (AICPA) recommends the “3-3-3 rule”—use one-third of the tax-refund check to pay down the credit-card debt that carries the highest interest rate; one-third should be applied to an emergency fund; and the final third can be used to spend on something fun.
“This way you’re moving closer to your long-term goals without totally giving up an immediate reward,” the AICPA says on its Feed the Pig consumer-advice website.
Some types of debt are better than others, however, Lew says. Mortgage debt helps because the interest payments are tax-deductible. If a consumer is strapped for cash, don’t burn the tax refund check by paying down a mortgage, she says.
“If your debt is a tax-deductible mortgage at 3 percent, then saving for retirement could be a better option,” Lew says.
Aside from how to use refund money, also keep in mind the various options for actually receiving a tax refund. The quickest way is via direct deposit from the IRS; the process is accelerated further by filing returns electronically.
The issue of Refund Transfer products is more complicated. Large tax-preparers, such as Liberty Tax Service and H&R Block, offer the ability to have fees deducted from the client’s refund check and the remainder loaded onto a prepaid debit card.
Almost 13 million consumers used tax-refund products in 2010, according to the American Coalition for Taxpayer Rights, a trade group that represents tax preparers and makers of tax-preparation software. It’s a popular and convenient method for consumers who don’t have a bank account to get their refund money faster, the Coalition says.
Some consumer advocacy groups, including the National Consumer Law Center, have warned against the product, however, saying that it’s simply another way to assess fees on the people who can least afford them and who need as much of their refund check as they can get.
Likewise, beware of tax refund loans disguised as a way to get your refund faster.
Consumers Union, the nonprofit organization that’s affiliated with the publication Consumer Reports, recommends avoiding lenders that use phrases like “fast cash refunds,” “super-fast cash,” or “instant money.” Those catchphrases are really just code for loans that carry triple-digit interest rates. Taxpayers can fall into a hole that’s hard to climb out of, when taking out loans with rates that high, Consumers Union says.
Other types of tax refund loans are available, however, which carry more consumer-friendly terms. The tax preparer Jackson Hewitt offers a 0 percent APR loan, carrying no fees, for customers who use its services to file their taxes. Only some consumers will qualify, however. You still need to pay for tax preparation fees.
Aside from the issue of loans, the top piece of advice for consumers is conducting an assessment of their personal debt situations.
“Go over your budget, spending habits, debts and savings,” Lew says.
However you decide to receive your tax refund, Lew offers the reminder that it’s best to not think of the refund as a way to feed your desire for an impulse purchase. Instead, think of boosting your long-term financial health, she says.
“Spending on an extravagant vacation that’s not within your means is highly advised against,” Lew says. “Don’t blow your tax refund check.”
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