Good News, Bad News for Tax Refunds

Small windfalls tend to be spent like gambling wins or bonuses. Will you use your tax refund wisely?

U.S. federal tax return 1040 form.
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Americans are far behind where they should be when it comes to retirement savings, financial planners say, and everyone knows it's because U.S. consumers are the world's biggest spendthrifts and debt holders. When tax refunds arrive, personal finance experts say people should regard the windfall as a chance to fix their shabby finances.

Consumers have less cash in their wallets this year than last because of a payroll tax hike at the start of the year. Still, jobs and housing are finally looking brighter, and that usually heralds more shopping from pent-up demand. History tells us that windfalls tend to be spent more like gambling wins or bonuses than like weekly paychecks.

So what do people say they are doing when they finally get those refund checks averaging almost $3,000?

They are saving it, according to surveys. And that's good news, say financial planners.

[Read: How the IRS Tracks Your Digital Footprints.]

Shopkeepers across the land see it as bad news. Their own trade group, the National Retail Federation, recently released a survey saying most people are saving and not spending. The trade group's president, Matthew Shay, sees that as regrettable because consumers should be "investing their hard-earned money"—on shopping trips that spur overall economic growth.

That might help the GDP, but David Batchelder, chief investment officer at Measured Wealth Private Client Group, LLC in New Hampshire, says it will not do much for most people's finances. Tax-refund recipients would be wise to avoid the siren call of the mall or costly vacation destinations and keep working to get their finances in order.

Tax refunds represent "one of the best chances a lot of people will get all year" to repair their finances, Batchelder says. If you do want to stroll the mall, avoid the travel agent and big-ticket purchases. His sage advice: "Go get an ice cream cone. That won't mess up your future."

Batchelder has his own "shopping list" of the three smartest things to do with that annual refund check. None of them involve strolls to the mall. They include:

1. Pay down high-interest rate debt. "That's No. 1 on my list for anyone who is getting a refund," says Batchelder. The best way to put the cash to work is to pay off a credit card requiring double-digit interest payments. By eliminating that payment, you are, in effect, gaining a double-digit return on your investment. That's hard to beat in this low-rate environment.

[Read: Are You Taking Enough Tax Deductions?]

The debt problem is still widespread, even after the deleveraging that took place in the recession. The Federal Reserve says U.S. consumers have $850 billion in credit card debt alone, or about $7,000 per household, and overall consumer debt of almost $23,000 per household. That includes auto loans and other personal debt, but not home mortgages (which amount to $13 trillion, according to Fed figures).

2. Fund your retirement account. "Time is running out to fund this year's accounts," says Batchelder. But even if you get a refund after April 15, he says, you can still take advantage of tax-deferred savings on your Individual Retirement Account (IRA) for the entire year. The tax deduction of up to $5,500 for 2013 (or $6,500 if you are over the age of 50) can be taken in the following tax year.

Why is this item so important? Many people lack sufficient funds for retirement. The Employee Benefit Research Institute (EBRI) reported in a recent study that 57 percent of workers have less than $25,000 put away.

3. Fund an emergency savings account. Putting aside your tax refund in an emergency account can help tide you over should a job loss or unexpected expense occur. It should be readily accessible cash. Keeping this amount in a savings account can play an important role in protecting your tax-deferred long-term savings. If you need to raid your IRA, you could incur a 10 percent penalty, unless you qualify for a hardship withdrawal. Either way, it generates an immediate tax liability and it is paid as ordinary income.