It’s been just a few days since the income tax filing deadline, and several clients & friends who filed early are already receiving income tax refunds. That brought up many questions regarding the best ways to use income tax refunds to make smart moves to get out of debt & improve your financial situation.
The Internal Revenue Service indicates that 78 percent of U.S. individual taxpayers receive an income tax refund. In 2008, the most recent information available, the average individual refund was nearly $3,000. Many surveys find that about half of U.S. taxpayers who receive an income tax refund spend the money immediately. Others are more prudent and save their refund. But what is the smartest way to use a tax refund?
1. Close down payday loans.
Few investments beat the rate of return for eliminating debt. For anyone carrying a payday loan, it will be the highest interest-rate debt they have. Often, a debt begins at just $100 to $300, but the interest and fees consumers pay on these loans can run into the triple digits every year. Therefore, if a consumer owes a payday lender, that is usually the No. 1 debt that they should pay off with a tax refund.
2. Pay down credit cards.
There are dozens of clients calling my office weekly telling me about the horrifying event of seeing the credit card interest rates skyrocket to over 20%. Overall, Credit cards average an interest rate of about 15 percent or more per year. Therefore, paying off credit card debt is like making an investment that earns that much. The key is for consumers to change their mindsets when they pay off that debt. Whether your refund can repay your debt completely, or make a big payment toward a large debt balance, promise yourself that you won’t repeat your mistakes. Cut up your credit cards or freeze them in a bowl of water if you don’t trust your willpower not to charge. Switch to cash to gain real debt relief.
To pay off debt, people save the most money by first paying the bill with the highest interest rate. But some people are more motivated by eliminating a debt completely. They can use a tax refund to pay off debts, beginning with the smallest balance first. The satisfaction of paying off a debt or two within the first few months can help motivate you to keep going to work towards the rest of your debts.
3. Build an emergency fund.
For those without major debt problems, a tax refund is instant savings, and can be used to start – or add to – an emergency fund. You can transfer the money to your savings account or even have it directly deposited. That can help with temptation. A small amount of savings can be kept in cash in a safe place, or in a savings account. Larger amounts can be kept in a money market fund or rolling CDs so the money earns interest and cannot easily be spent, but can be accessed in an emergency. (For a free high-yield savings account check out HSBC or ING Direct)
Taxpayers should remember that it is always a good idea to build toward an emergency fund that would cover six months’ of expenses. You never know what could come your way, and many times the emergency savings is the first line of defense towards a job loss, family emergency, or other economic hardship.
4. Insure the home and family.
Everyone should have health, auto, and home or renters insurance. If dependents rely on breadwinners’ income, the heads of the household should look into life insurance. An umbrella policy is a relatively inexpensive way to protect from additional liability. And if the household could not survive without an income, purchase disability coverage. Proper insurance can shield savings, because one trip to the emergency room or one minor accident can easily end up costing thousands or tens of thousands of dollars out of pocket.
5. Fund the future.
Contribute to retirement savings, whether an individual or Roth IRA, 401(k) or other plan. If the program is tax-deductible, it helps next year’s tax picture, too.
6. Get educated.
Parents can put money toward a college savings plan for a child, or adults can strengthen their own financial future by continuing their education. A $3,000 tax refund would make significant headway toward an associate’s degree, for instance. Higher education can return the investment. Associate’s degree holders earn 23 percent higher salaries than high school graduates, and those who receive a bachelor’s degree earn even more.
7. Invest in the home.
Homeowners might consider using refunds to cover major or minor maintenance to make sure no bigger (and more expensive) problems arise down the road. In addition, these capital improvements can help build additional equity.