Use Your Foolish Refund Wisely
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 off or pay down the credit card debt. Let's say you're getting a refund of $1,500 but you have $3,000 in credit card debt. Even when you are in debt, it's important to have some cash in reserve. Otherwise, if an unplanned expense arises, such as a car repair, you end up going further into debt. Save $500 of the refund money and apply the remaining $1,000 to the credit card bill.
You may think, what's the use, because you'd still owe $2,000. But look at it a different way. You would have eliminated more than 33 percent of the debt.
Situation Two: You have some money put away for 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 managed to save only about one month's worth of living expenses. You have $2,000 in outstanding credit card debt. Your tax refund will be about $2,000.
Don't worry about reaching the emergency fund target. You've made a good start. Pay off the credit card. With that debt gone, you can 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.