The Internal Revenue Service indicates that 78 percent of U.S. individual taxpayers receive an income tax refund. In 2008, the most recent information available, the average individual refund was nearly $3,000. Many surveys find that about half of U.S. taxpayers who receive an income tax refund spend the money immediately. Others are more prudent and save their refund. But what is the smartest way to use a tax refund
Freedom Debt Relief analyzed several top choices and prioritized them as they apply to most taxpayers:
1. Close down payday loans.
Few investments beat the rate of return for eliminating debt. For anyone carrying a payday loan, it will be the highest interest-rate debt they have. Often, a debt begins at just $100 to $300, but the interest and fees consumers pay on these loans can run into the triple digits every year. Therefore, if a consumer owes a payday lender, that is usually the No. 1 debt that they should pay off with a tax refund.
2. Pay down credit cards.
Credit cards average an interest rate of about 15 percent or more per year. Therefore, paying off credit card debt is like making an investment that earns that much. The only caveat, Gallegos said, is that consumers must change their mindsets when they pay off that debt. "If you repay debts, but then go right back into debt again, you wind up at square one," Gallegos said. "Whether your refund can repay your debt completely, or make a big payment toward a large debt balance, promise yourself that you won't repeat your mistakes. Cut up your credit cards or freeze them in a bowl of water if you don't trust your willpower not to charge. Switch to cash to gain real debt relief."
To pay off debt, people save the most money by first paying the bill with the highest interest rate. But some people are more motivated by eliminating a debt completely. They can use a tax refund to pay off debts, beginning with the smallest balance first. "Sometimes, that sense of satisfaction can really inspire people to keep going to work toward debt freedom," Gallegos said.
3. Build an emergency fund.
For those without major debt problems, a tax refund is instant savings, and can be used to start - or add to - an emergency fund. "It can feel great to jump-start savings," Gallegos said. "You can even have your tax refund deposited directly into a savings account. That way, you will not be tempted to spend the refund immediately, and can earmark the funds for emergency purposes." A small amount of savings can be kept in cash in a safe place, or in a savings account. Larger amounts can be kept in a money market fund or rolling CDs so the money earns interest and cannot easily be spent, but can be accessed in an emergency.
Taxpayers should remember that it is always a good idea to build toward an emergency fund that would cover six months' of expenses. "In this ever-changing economy and job market, it is a good idea to be prepared for whatever comes your way," explained Gallegos.
4. Insure the home and family.
Everyone should have health, auto, and home or renters insurance. If dependents rely on breadwinners' income, the heads of the household should look into life insurance. An umbrella policy is a relatively inexpensive way to protect from additional liability. And if the household could not survive without an income, purchase disability coverage. Proper insurance can shield savings, because one trip to the emergency room or one minor accident can easily end up costing thousands or tens of thousands of dollars out of pocket.
5. Fund the future.
Contribute to retirement savings, whether an individual or Roth IRA, 401(k) or other plan. If the program is tax-deductible, it helps next year's tax picture, too.
6. Get educated.
Parents can put money toward a college savings plan for a child, or adults can strengthen their own financial future by continuing their education. A $3,000 tax refund would make significant headway toward an associate's degree, for instance. Higher education can return the investment. Associate's degree holders earn 23 percent higher salaries than high school graduates, and those who receive a bachelor's degree earn even more.
7. Invest in the home.
Homeowners might consider using refunds to cover major or minor maintenance to make sure no bigger (and more expensive) problems arise down the road. In addition, these capital improvements can help build additional equity.
"It is not every day that the average individual receives an extra $3,000," Gallegos said. "In that way, many U.S. taxpayers receive a gift each spring - and the wise person will use that gift to get out of debt and move ahead financially."
Freedom Debt Relief provides consumer debt resolution services. Working as an independent advocate for consumers to negotiate with creditors and lower principal balances due, the company has resolved more than $1 billion in debt for nearly 100,000 clients since 2002. The company is a charter member of The Association of Settlement Companies and a platinum member of the International Association of Professional Debt Arbitrators. FDR holds the Goldline Research Preferred Provider certification for excellence among debt settlement companies.
Freedom Debt Relief is a wholly owned subsidiary of Freedom Financial Network, LLC (FFN). Based in San Mateo, Calif., FFN also operates an office in Tempe, Ariz. The company, with more than 500 employees, was voted one of the best places to work in the San Francisco Bay area in 2008 and 2009, and in the Phoenix area in 2008, 2009 and 2010. FFN's founders received the Northern California Ernst & Young Entrepreneur of the Year Award in 2008.