By Jason Alderman
Each spring, millions of Americans look forward to receiving a hefty income tax refund. And it truly is “hefty” with the average federal refund in 2010 hovering around $3,000. That’s a lot of money to be giving the government through what is essentially a year-long, interest-free loan.
If you regularly receive large refunds, you’re probably having too much tax withheld from your paycheck. Instead, you might want to withhold less and put the money to work for you, by either saving or investing a comparable amount each month, or using it to pay down debt. Your goal should be to receive little or no refund at the end of the year.
Ask your employer for a new W-4 form and recalculate your withholding allowance using the IRS Withholding Calculator available at www.irs.gov. This is also a good idea whenever your pay or family situation changes significantly (e.g., pay increase, marriage, divorce, new child, etc.) Just be careful, because if too little is deducted, you might end up owing more tax next April, and possibly even interest or penalty fees. IRS Publication 919 can help guide you through the decision-making process.
Some people received larger-than-normal tax refunds in 2009 and 2010 thanks to the Making Work Pay credit, which expired December 31, 2010. In its place, most taxpayers will see a 2 percent reduction in the amount being withheld for Social Security in 2011 paychecks.
Another change this year was a Treasury Department pilot program that offered 600,000 randomly selected low- and moderate-income families an opportunity to have their tax refunds direct- deposited into a prepaid debit card issued through Bonneville Bank. The pilot explored ways to save the government money (direct deposits cost 1/10th as much to process as paper checks) as well as to give people with no bank account easier and more cost-effective access to their tax refunds.
Here are ways to put your refund to good use:
Pay down debt. By increasing your payment amount on outstanding loan or credit card balances you can significantly lower the total amount of interest paid. Say you’re paying $80 a month on a $2,000 credit card balance at 18 percent interest. By doubling your payment to $160, you’ll reduce the payoff time from 32 months to 14, and shave $295 off the total amount of interest paid.
Start an emergency fund. To protect your family against the impact of a layoff or other unexpected financial crisis (such as a medical emergency, car accident or theft), set aside enough cash to cover at least six months of living expenses.
Save for retirement. If your debt and emergency savings are under control, add to your IRA or 401(k) accounts, particularly if your employer matches contributions – a 50 percent match corresponds to a 50 percent rate of return.
Invest in yourself. Enroll in college courses or vocational training to ensure you have additional skills to fall back on should you lose your job or want to change careers.
Invest in your family’s future. Another good use for your refund is to set up a 529 Qualified State Tuition Plan or a Coverdell Education Savings Account to fund your children’s or grandchildren’s education – all while ensuring your contributions will grow tax-free until withdrawn.
Jason Alderman directs Visa’s financial education programs. To participate in a free, online Financial Literacy and Education Summit on April 4, 2011, go to www.practicalmoneyskills.com/summit2011.
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