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Thread: Be Smart About Your Tax Refund
01-30-2009, 06:29 PM #1
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Be Smart About Your Tax Refund
Be smart about how you spend tax refund
By Michelle Singletary
March 16, 2008
For years I've been begging people not to use tax withholding as a forced savings tool.
I understand the reasoning. Times are tight and people want some financial security, even if it means letting the federal government keep their money out of fear they will waste it throughout the year.
But if you are going to continue being hardheaded just to get a tax refund, what should you do with it? For example, I received this question from a participant in a recent online discussion: "We're going to get a $7,500-plus tax refund. I'm not sure how that's possible, but I triple-checked our return. Should we use the refund to pay down our mortgage?"
Rather than discuss once again why getting a refund is not a good idea unless it is prompted by a change in your tax situation - birth of a child, marriage, home purchase - I want to talk about what to do with the money under certain circumstances.
Situation One: You have no emergency fund and lots of credit-card debt.
In this case, set aside some of the refund and use the rest to pay credit cards. For example, let's say you're getting a $1,500 refund but you have $3,000 in credit-ard debt. Even when you are in debt, it's important to have some cash in reserve. Otherwise, if an unplanned expense arises, like a car repair, you end up further in debt. Save $500 and take the remaining $1,000 and pay the credit card.
You will have eliminated more than 33 percent of the debt.
Situation Two: You have an emergency fund but not the recommended minimum of three months of living expenses. You have some credit card debt.
Let's say you've only managed to save one month's worth of expenses. You have $2,000 in credit-card debt. Your tax refund will be about $2,000. Pay off the credit card. With that debt gone, you can take the money you were paying for the debt and continue building up your emergency fund.
Situation Three: You have an emergency fund equal to three months of living expenses. You have no credit-card debt, but you have car and student loan debt. You're getting a tax refund of $5,000. The interest rate on your student loan is under 6 percent. But the remaining balance on your car loan is $6,000 at 8 percent.
Pay down the car loan.
Situation Four: You have three months of expenses saved. You have no credit-card debt, no car loan. But you have $10,000 in student loans. Your refund is $4,000.
Reduce the student loan. But wait, you say, I could invest that money and earn more than the interest rate on my student loans. Or you might argue that it's OK to keep the debt because you get a tax deduction for some or all of the interest you pay.
Yes, in theory the math can work out and put you ahead if you invest the money from your refund. But you haven't factored in risk and human nature. There is no guarantee that money invested will yield a return that would be substantially greater than the interest you pay on the loan. And I've found people who say they will invest the money but often don't. Yes, you lose the deduction if you pay off the debt, but you save more in not having to pay the interest.
Additionally, student-loan debt these days isn't cheap. The National Consumer Law Center found that the average annual interest rate of private student loans the group examined was 11.5 percent.
As the price of college has increased and family incomes, grant aid, and federal loans have failed to keep pace, private loan borrowing has skyrocketed and now equals about 24 percent of education-loan volume, according to the College Board.
Situation Five: You have more than enough in cash reserves and no other debt except a mortgage.
Before paying down the mortgage, consider two things. If you have children, you might want to boost their college funds or start one. Also, review your retirement savings to determine if you are on track. If you have substantial savings and are meeting your savings and investment goals in other areas, then attack the mortgage. Generally, by making one extra mortgage payment a year you will reduce a 30-year loan to about 22 years.
What I'm saying is if you're going to do a dumb thing and keep getting refunds unnecessarily, at least be smart about how you use the lump sum.
Michelle Singletary is a columnist for The Washington Post. She can be reached at email@example.com
Last edited by d_awalker; 02-02-2009 at 11:15 PM.