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Use Your Tax Refund Wisely

Are you expecting a big federal tax refund this year? You are not alone. Due to 2003 tax law changes that lowered marginal tax brackets, many people are expecting a four-figure check. This is especially true for workers who did not decrease their tax withholding to compensate for lower tax rates.

Tax refunds can be a wonderful financial windfall. Unfortunately, too many people receive substantially less than they are due because they take out expensive loans to get an instant refund. According to a January 2004 study by the Consumer Federation of America (CFA) and the National Consumer Law Center (NCLC), consumers paid an estimated $1.14 billion in fees for refund anticipation loans in 2002 and an additional $406 million in administrative or filing fees. Refund anticipation loans (RALs) are high-cost, short-term loans secured by a taxpayer's expected tax refund.

Studies show that many consumers are unaware that RALs are loans, let alone have any knowledge of their high cost. A recent survey of consumers in Virginia and Arizona found that over 80% of RAL consumers did not realize that they had gotten a loan. RALs generally last about 10 days, which is about the time it takes to receive a refund from an electronically filed tax return. High fees for these short-term loans generally translate into triple digit annualized interest rates.

During the 2002 tax-filing season, just under 10% of all individual tax returns and 36% of low-to-moderate-income earned income tax credit (EITC) recipients received RALs. Some of the major "players" in the RAL industry include large national tax preparation firms, finance companies, and high-cost "fringe financial providers" such as payday lenders, check cashers, and rent-to-own stores.

What if you really need your tax refund money immediately and can't wait for your refund check? There are several cheaper alternatives to RALs. Other options for quick cash include short-term loans from family or friends, credit union loans, and credit card cash advances. If you e-file your return, you should have your money in 2 weeks or less. File a paper return with direct deposit of your refund to a bank account and the turn-around time is often less than a month.

While you're waiting for your tax refund, make plans to use it wisely. Below are a dozen suggestions to increase your financial health:

1. Pay off high-cost debt (e.g., credit card bills).
2. Start or replenish an emergency fund of 3 to 6 months' expenses.
3. Start or increase deposits to tax-deferred employer savings (e.g., a 401(k) plan). Use your refund to offset the reduced take-home pay that will result from making increased plan contributions.
4. Fund a traditional or Roth individual retirement account (IRA). The maximum contribution allowed in 2004 is $3,000 plus an additional $500 for workers age 50 and over.
5. Start or increase deposits to a 529-college savings plan for your children or grandchildren.
6. Refinance your mortgage and use the refund to pay necessary closing costs.
7. Make extra principal payments on your mortgage to shorten its term and lower the total cost.
8. Invest in home improvements that have a high payback, such as landscaping and kitchen upgrades.
9. Purchase necessary business equipment (e.g., a computer) if you are self-employed.
10. Buy a needed "big ticket" item, such furniture or a major appliance, for cash instead of using a credit card.
11. Purchase a few hours of a certified financial planner's time to get advice and a financial check-up.
12. Donate all or part of your refund to support a worthwhile charity and receive a 2004 tax write-off.

There's just one more thing that taxpayers should consider doing. Change your tax withholding to increase your take-home pay now and lend less money interest-free to the Federal government. To do this, contact your employer's payroll office and file a new W-4 withholding form.