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Personal Finance: What to Do with That Tax Refund


April 24, 2011 (The Sacramento Bee, Calif.) With tax day in the rear-view mirror, many Americans are now looking ahead to their much-anticipated tax refund.



If you're the average taxpayer getting money back from the IRS this year, you'll be sitting on an extra $3,000 or so sometime soon. That's a nice chunk of change. As for what to do with that extra income, there's plenty of advice out there: spend, save, splurge.

So what are most of us planning to do? More than a third of Americans getting a refund -- 37 percent -- intend to spend part or all of it, according to a Capital One Bank survey last month. Of those, the majority say they'll use it for everyday expenses (23 percent), followed by new clothes/accessories (11 percent), a vacation (6 percent), or electronics such as a new iPad or flat-screen TV (4 percent).

Thirty-one percent plan to save at least part of their tax refund, while 19 percent intend to pay down debt. What do the experts say?

Here are some suggestions from several financial advisers on how to spend the average $3,000 refund. Gregory Lucas, a certified financial planner in Sacramento, said he'd make recommendations based on age and interests.

For younger clients in their 20s and 30s with years ahead to save for retirement, Lucas recommends doing a Roth IRA conversion. A $3,000 refund will pay the one-time tax needed to convert a $10,000 regular IRA into a Roth IRA, he said.

"It can generate big results and it'll make their IRA completely tax-free for life." In 50 years, at 7 per- cent interest, that $10,000 Roth will be worth almost $300,000, he noted.

For those in their 40s and older who are stuck with consumer debt, he suggests paying down credit cards. Use the $3,000 to reduce the balance on the card with the highest interest rate.

"If you're on a typical credit card paying 20 percent interest and not paying anything on the principal, you'll save $50 a month just in interest," Lucas said. Each month, apply that $50 savings to another credit card or other debt and in five years, he said, you'll have saved $13,175 in interest.

Another suggestion by Lucas: Invest in home energy improvements through your public utility that are eligible for rebates and tax credits. It's possible to re- cover the $3,000 cost through energy savings in 36 to 48 months, Lucas said, "and then you can enjoy the benefits for years."

No matter your age, if you have zero debt and sufficient savings, then by all means treat yourself -- and help boost the economy at the same time -- said Farnoosh Torabi, a personal finance expert with Credit.com, an online consumer site.

Otherwise, she said, the "hierarchy of action" with a tax refund is using to pay down debt, build savings and, lastly, spend it.

"If you have debt and no savings, split the refund 50/50 between those first two buckets," she said.

If you're in your 20s or 30s, presumably with some debt carrying over from college, Torabi recommends using the refund "to chip away at your highest interest debt, be it credit card balances or student loans."

For those in their 40s and 50s, Torabi recommends reviewing your retirement funds to see if you need to "play some catch-up" by adding to your 401(k) or traditional IRA.

"The fact is most boomers are unprepared financially for retirement.

You may not want to in- vest your tax refund in the stock market at this point, but it may be worth tucking some into a traditional 'rainy day' account. With so much uncertainty in the world of health care, every extra dollar will help better secure your life and health in retirement."

Of course, conventional money wisdom is that getting a refund means you paid too much to the IRS or state during the year.

Instead, many experts advise, you should adjust your paycheck withholding rates in order to keep that money in your pocket all year, rather than get it back after tax season.

Not everyone agrees. All that don't-take-a-refund advice isn't realistic, says personal finance blogger and author Ramit Sethi, a native Sacramentan who now works in New York.

In a recent blog post titled "Your parents are delusional about tax refunds," Sethi urged people to stop feeling guilty if they're getting money back on their federal or state taxes.

Too many financial experts -- and parents -- he said, will "lecture you about taxes ... 'If you're getting a tax refund, you're giving the government free money!' "

While that may be true, he said, the amount of interest earned on $3,000 is about $2.50 a month. Or as Sethi put it: "I have that much money in my shoe right now."

Most people, he said, simply won't change their withholding and psychologically prefer to get the big check, rather than pay less during the year.

His advice if you're getting a refund: Reward yourself, within limits. "Take 10 percent of that refund and spend it on something you love. Like a trip to visit a friend or that sweater you've been wanting," said Sethi, author of "I Will Teach You to be Rich."

Why? Feeling good about money can be motivating, says Sethi, inspiring you to keep earning enough to generate another unexpected boost in income.

But aside from the feel-good psychology, Sethi also has some grounded financial advice for unexpected income like a refund.

"If you have debt, use this to pay it off. That $3,000 can make a huge difference. If you don't have debt, good for you. It's a great time to fund your retirement account."

That could mean pumping up your 401(k) contribution to get your employer's match, opening a Roth IRA, or investing in a simple, low-cost "target date" retirement fund, he said.

For the average $3,000 refund, 10 percent is still a decent amount of money: $300.

"Spend some of it and reward yourself, said Sethi. "With the rest, do the right thing for your long-term financial focus."

Copyright (c) 2011, The Sacramento Bee, Calif.

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