Roughly $100 billion is expected to land in 90 million American mailboxes and bank accounts over the next several weeks–the last gasp of tax filing season. That’s the rough estimate of how much–and how many–American taxpayers will be getting in federal tax refunds this year.
With individual checks averaging more than $1,400 so far, it’s no wonder that figuring out how to spend the refund money is practically a national pastime.
Economists say that tax refund time produces a seasonal blip in the economy because so many people spend so much money in so little time.
However, before you weigh the various spending options, consider whether there are better uses for the money. Properly deployed, that tax refund could go a long way to making you financially healthier now and in the future.
So what should you do with the money?
– Pay off credit card debts. The average American still carries a credit card balance and often they’re paying interest of 15 percent per year–or substantially more. It may not be exciting, but you should consider paying down your debts the equivalent of investing your money, says Gregg Ritchie, partner in the personal financial planning group at KPMG Peat Marwick. And a guaranteed 15 percent rate of return isn’t half bad.
– Join your company’s 401(k) plan or boost your existing contributions. Let’s say you’re getting a $1,200 refund. That’s $100 a month. Now let’s say that your company offers a 401(k) plan and kicks in 25 percent of what you contribute–the bulk of the nation’s employers offer a company “match.” But you’ve never contributed because you figure you can’t afford to do without the $100 a month.
So, you put the $1,200 in a bank account to be tapped if you need it to handle monthly living expenses and you sign up for the 401(k) option, contributing just $100 a month, suggests Kathy Stepp, partner at Stepp & Garrett, a financial planning firm headquartered in Overland Park, Kansas.
What happens? Assuming you’re in the 28 percent tax bracket, your paycheck declines by just $72 a month. That’s because the 401(k) contributions come out before taxes are deducted. The IRS acts as if you never earned the money. So from Uncle Sam’s perspective, you earned less money and needed to pay less tax. The end result: You’re $28 per month richer. So at the end of the year–assuming you really needed to spend every dime of your paycheck–you still have $336 in savings, plus interest.
Meanwhile, between the $100 per month that you’re saving in your 401(k) and the $25 per month that your employer kicks in, your retirement account is growing by $125 per month–before accounting for an investment return. At the end of the year, you have $1,556 in your account–assuming a reasonable 8 percent rate of return. At the end of five years, you have more than $9,000. At the end of 10 years, you have a tidy $22,868. If you continue to contribute at the same rate and return for 30 years, you’ve got $186,295.
– Start an individual retirement account. If you don’t have access to an employer-sponsored retirement plan, such as a 401(k), 457 or 403(b), consider contributing to an IRA. You can set up an IRA account at a bank, brokerage or mutual fund company and invest the money however you see fit. Assuming you meet the criteria–you aren’t covered by another qualified pension or you earn less than certain threshold amounts–up to $2,000 of IRA contributions are tax deductible, too. What does that do for you? If you’re in the 28 percent bracket and you contribute the full $2,000 to an IRA, you reduce your federal income taxes by $560 and you may get a break on your state tax, too. And, naturally, you get the benefit of tax-deferred earnings on the money you’re saving.
– Make sure you get the check. One thing many people apparently forget is the actual refund. Every year, the IRS ends up with somewhere in the neighborhood of 90,000 to 100,000 checks that were “undeliverable,” says Keith Kimball, an IRS spokesman in Los Angeles. In 1996, 96,400 checks went unclaimed at IRS offices around the country. How could that happen? The IRS blames it on people who move frequently or write their addresses illegibly. But the agency also acknowledges its own data processing errors contribute, too.
If you haven’t received your check within six to eight weeks after filing a return, call the IRS at 800-829-1040.
– Make sure you don’t get another refund. OK, everybody likes refunds. It’s like a present. Found money. A forced savings plan. A gift. But, in fact, it’s not a gift. When you get a refund, you have effectively lent the government money–a zero interest loan–and then you’ve had to file a form to get them to pay your money back. The government won’t lend you money at zero interest. So, what are you thinking?
If you consistently get refunds, go into your employer and adjust your withholding, says Ritchie. In most companies, your payroll clerk will help you figure out just how many exemptions you need to claim to get the withholding just right. Then you’ll be getting your money throughout the year and you can spend it or save it as you see fit.
