How to Use Your Tax Refund

Getting a tax refund is an opportunity to make some smart financial decisions. This money can beef up savings and whittle down debt. But the wisest course is to adjust your withholding to avoid getting a refund in the first place.

The average tax refund was $3,000 in 2012, so many people receive enough to greatly enhance their financial situation. Here are a few smart ways to use your tax refund. 

Pay off debt. This is the first thing to do with your refund. Dedicating a lump sum toward your debt is a great way to make it more manageable. Start with high-interest credit card debt, and move on to the lower-interest mortgages or student loans.

Paying off high interest debt is an excellent financial move. Any extra dollar you put toward a debt saves you that percentage of interest over the next year. For example, if you have a credit card with an 18% interest rate, you essentially earn an 18% return on every dollar you pay off, since you avoid that interest. Paring $3,000 of debt at that rate saves you $540 over the following year.

Build your emergency fund. Everyone should have three to six months of living expenses in a liquid cash reserve. But not everyone has enough saved. A tax refund is your chance to start a reserve if you don’t already have one, or to replenish it. You can check www.DepositAccounts.com or www.BankRate.com to find a no-fee, high-interest savings or money market account to use for your emergency fund.

Fund an individual retirement account. You have until April 15 to make an IRA contribution for 2012, but if you miss that deadline, you can still get a head start on 2013. Funding an IRA is a great way to prepare for retirement, and you can choose between traditional IRAs that give you a tax deduction now or Roth IRAs that provide tax-free income in retirement.

The maximum contribution for tax year 2012 is $5,000, or $6,000 for those over 50, as long as you had at least this amount of earned income for the year. Both contribution limits are $500 higher for 2013.  

Boost your college savings. It’s difficult to juggle saving for retirement with other financial goals like preparing for your children’s college education expenses. Using a tax refund as a lump sum contribution toward college savings can be a great way to fund their education without adding an extra monthly bill.

You can go to www.savingforcollege.com to learn more about the different types of college savings plans.

While it feels like a windfall, a tax refund is really just money you overpaid throughout the year, so it's basically an interest-free loan to Uncle Sam. Instead of overpaying and receiving a refund, use the Internal Revenue Service’s Form W-4 to adjust your tax withholding and keep more of your money throughout the year. The IRS doesn't like it when you underpay, so consult your advisor or tax preparer for help determining your tax withholding.

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Neil Vannoy, MBA, CFP, is president of Vannoy Advisory Group, a fee-only financial planning firm with offices in Round Rock, San Antonio and Waco, Texas. 
 
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