Use that income tax refund to trim debt, build for future

PERSONAL FINANCE

Tax refund can be a help down the road

April 06, 2003|By EILEEN AMBROSE

THE AVERAGE federal tax refund this year is $2,010 - what Tiger Woods earns in about 4 1/2 minutes.

But for most taxpayers, that's real money. It's about two weeks' pay for the typical emergency room nurse and high school teacher, or three weeks' salary for an insurance agent or entry-level accountant, according to Salary.com. It's also one month's wages for a chauffeur, motel manager or rookie reporter.

Too often, taxpayers put a sizable refund in their checking accounts and end up spending it, said Mary Malgoire, a financial planner with The Family Firm in Bethesda.

"The inclination is, 'I always deserved that cruise. Why don't I do that? I would really like to get my spouse something really nice. Why don't I do that?' " she said. "You're selling out your future for current satisfaction by doing that."

She suggests that taxpayers use the refund to produce greater long-term benefits, such as funding retirement or a college education. "We're not hoarders and we ought to cultivate that like a fine wine - the wonderfulness of hoarding," she said.

Here are other refund ideas:

Pay off credit-card debt. Consumers can save hundreds or thousands of dollars by getting rid of high-interest card debt, one reason why this should be the first place to apply a refund, financial experts said.

For instance, if you have a $2,000 balance on a card with a 14 percent interest rate, it would take a little over 16 years to wipe out that debt by making the minimum payment, and you would have paid $2,100 in interest, said Gerri Detweiler, author of the Ultimate Credit Handbook. "So you could save yourself the amount of the refund by paying it off right away," Detweiler said.

Build an emergency fund. The rule of thumb is salting away up to six months' worth of living expenses that can be tapped for emergencies. This way, if the roof springs a leak, you don't have to rack up credit-card debt to take care of the problem.

Add to retirement savings. Contribute to a traditional or Roth individual retirement account. Maximum annual contributions are $3,000, or $3,500 for those 50 or older.

Or, put the refund in a money market fund or other account that you won't be tempted to tap and increase your contributions to your 401(k), Malgoire said. Your paycheck will be smaller, but you can take money from savings during the year to make up the difference.

Repay a 401(k) loan. Workers often figure there's little harm in borrowing from a 401(k)because they pay themselves the interest on the loan, said Phillip Cook, a financial planner in Torrance, Calif. The problem is that the loans are repaid with dollars that have already been taxed, and that money will be taxed again when withdrawals are made in retirement, Cook said.

Loans should be avoided, and those who have them should pay them back quickly, he said.

"The sooner you stop the interest from running, and more importantly, the sooner you get your money back into those investments that should do well, the better off you are," he said.

Save for college. Contribute to a 529 college savings plan for a child. There are no income limits for eligibility. Contributors choose among investments in the plan, and withdrawals are tax-free if the money is used for college. The law permitting tax-free withdrawals expires in 2011, unless Congress extends it.

Many states that offer the plans, including Maryland, give residents a tax deduction for all or part of their contributions.

Another option is the Coverdell Education Savings Account. The maximum annual contribution is $2,000. Full or reduced contributions can be made by singles with incomes under $110,000 and married joint-filers earning less than $220,000.

Investors control how the money is invested. Tax-free withdrawals are permitted to pay costs of kindergarten through college.

Reduce mortgage debt. Using a $2,000 refund to pay down the principal of a mortgage can trim a year or two off the loan's term, said Grace Worley, a financial planner in Indianapolis.

While some experts suggest homeowners are better off investing money for retirement than paying off a low-interest mortgage loan early, Worley said people rarely do this.

"I'm not a proponent of maintaining mortgage debt as a way to leverage savings and investing more money. You should do both, pay down debt and do investing," Worley said. "When a person gets ready to retire, the ones that don't have any debt are facing a more comfortable retirement than those that do."

Those regularly getting hefty refunds should adjust their tax withholding, experts said.

"If you get that much back, you gave Uncle Sam an interest-free loan for the year," said Joanne Hamilton, an educator with the University of Maryland Cooperative Extension in Anne Arundel County. "That's a lot of money you didn't make any money on."

Most workers declare withholding by filling out the front page of the W-4 form when they start a job, but rarely revise it, said Alan Friedland, a Cockeysville accountant.

To fine-tune withholding, though, filers should revisit the W-4 and do the more extensive calculations on the back, he said.

To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose @baltsun.com.

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