As we enter the heart of tax season, many taxpayers will soon find themselves with a large chunk of money. The average tax refund last year was more than $3,000. That's a lot of money, and it's easy to spend but not have much to show for it. Here are four ways your tax refund can make a big impact in your financial life.
First, make sure you set up direct deposit so you get your refund as quickly as possible. When you establish direct deposit, the money is deposited the moment it's ready. If you elect to receive a check, that check has to be printed and mailed, adding a few days (assuming it isn't lost). When you deposit that check, it needs to clear, which takes even more time.
[See Take Advantage of These Tax Breaks.]
Emergency fund. If you don't have an emergency fund or you don't have an adequately funded one, use part of your tax refund to start or boost your emergency fund. Emergency funds are an important financial tool because they insulate you from unexpected financial shocks. Experts recommend that you have, at a minimum, a six-month emergency fund to help you weather difficult times. By having an emergency fund, you have a safe pool of cash available to respond to problems. Without one, you may have to rely on credit cards, which come with high interest rates, which can magnify the original emergency.
In deciding where to put your emergency fund cash, I recommend high-interest savings accounts. Don't put it in the stock market to try to get a few extra percentage points in gains--that's way too risky. Keep it in a safe place.
Pay down debt. After bolstering your emergency fund, you should take a look at your debts and pick one to pay down. Debt, especially higher-interest credit card debt, acts as a weight on your finances. Paying double-digit interest rates drag down the growth of your net worth because a percentage of your income has to go toward servicing your existing debt. By paying off some of the principal using this newfound money, you give yourself an advantage in catching up. If you are getting close to paying off the debt, consider taking advantage of 0 percent balance transfers, especially on high-interest credit card debt, so you get an even bigger jump during the promotional period.
If you have a mortgage and have considered refinancing, this might be a good time to take another look. You can use part of the tax return to pay any closing costs that might be associated with the refinancing. You're not really paying down debt in the traditional sense, but a lower interest rate means you pay less in interest over the long run.
[See 4 Tax Breaks of Homeownership.]
Fund your IRA. Contributing to a traditional or Roth IRA is a great way to invest in yourself and your retirement, but it's often difficult to find the money to put into those accounts, especially if your budget has been stretched to the limit. If you are without debt and have an emergency fund, funding your IRA with your tax refund is on option you should consider. Roth IRAs take after-tax contributions, so you get no immediate tax benefit for contributing, but the growth is completely tax-free. Traditional IRAs take pre-tax contributions, so you get a deduction if you qualify, but you pay taxes when you take disbursements from the IRA.
Have fun. Finally, take a little bit of that return and have some fun with it. Reward yourself for bolstering your emergency fund or paying down debt by treating yourself to a nice dinner or buying that gadget or gizmo you had your eye on. All work and no play is no fun, and rewarding yourself for doing the right thing reinforces that good behavior. If nothing else, you can always put it toward your next vacation.
Jim Wang writes about personal finance at Bargaineering.com. When he's not tackling money issues, he's usually looking forward to his next vacation and writing about it at Wanderlust Journey.
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Kama of VA 3:55PM February 24, 2012
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