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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, 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: Complete a new W-4 form so your employer withholds the correct amount from your paycheck. This recalculation is especially important if your income level or family situation changes – for example, new kids, fewer dependents, marriage or divorce, etc. Your goal should be to receive little or no refund.
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.
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 another debt.
Save for emergencies. To protect against layoffs or other unexpected financial crises, build up your savings to cover six months of living expenses. It’s best to keep emergency savings in accounts like a money market account that you can access easily paying without 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 then a traditional savings or checking account. Numerous websites track high-yield accounts including www.highyieldcheckingdeals.com and www.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, since that’s like getting free money. Practical Money Skills for Life, Visa Inc.’s free personal financial management program, contains detailed retirement financial planning information such as how 401(k) plans work, tax ramifications and interactive retirement savings calculators (www.practicalmoneyskills.com/401k).
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. Not every product qualifies, so visit the government’s Energy Star website for details before you buy (www.energystar.gov/taxcredits).
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.