Newswise — Expect a large tax refund this year? Forget buying a boat, taking a cruise or squandering the money some other way, cautioned Margaret Van Brunt, assistant dean of the Rohrer College of Business at Rowan University, and Rick Marmon, associate professor of accounting and finance, both certified public accountants who together have more than 50 years of professional experience.
Van Brunt said the Internal Revenue Service estimates about 75 percent of taxpayers get a refund, which in 2005 averaged more than $2,000. "A cash windfall like this, of course, has Americans across the country struggling with tough decisions, like whether they should buy the plasma TV or book that last-minute cruise. As tempting as it may be, consumers would be far better off resisting the temptation," she said.
Van Brunt and Marmon have five suggestions of what to do — or not do — with a major refund:
1) Avoid the refund-anticipation loan. Don't borrow against your expected refund. Despite numerous warnings by consumer-watchdog groups and reams of bad press, refund-anticipation loans — which allow taxpayers to borrow against their expected refund — continue to be a popular waste of money. The appeal of these loans is that they deliver cash in a day or two, via a tax preparer, who's repaid when the real refund arrives. The problem with these loans is that they don't come cheap. Typically, borrowers pay about $30 to $165 (costs vary, in part, by the loan amount) for what typically turns out to be roughly a 10-day loan. The cost usually includes administrative fees as well as interest charges, which can be downright usurious. That's not the only problem. If, for some reason, the refund is held up or denied by the IRS, you still owe on the loan.
" We advise not to shrink refunds before they even arrive. For those with a real need for fast cash, a better option is simply to file electronically and have the refund deposited directly into a checking or savings account. Opting for this faster treatment has no cost and should deliver the refund in about 10 business days, rather than the four to six weeks it takes via snail mail," said Marmon.
Some people take out a refund-anticipation loan as a means of paying for their tax preparation. The tax preparers encourage this by allowing the taxpayer to deduct the cost of preparation from their refund-anticipation loan. (In other words, the loan includes the cost of the tax preparation, which is then covered when the refund arrives.) But these days, just about anyone can file his or her tax returns for free online through the IRS Web site.
2) Save your refund. Everyone should have a bit of extra cushion in his or her budget in case of the unexpected, such a job loss, illness or injury. A tax refund can help build that cushion. An emergency fund should consist of three to six months' worth of living expenses held in a cash account like a money-market fund. Unfortunately, with interest rates so low, people earn next to nothing on their money. But just knowing it's there can be a source of comfort when times get tough.
3) Contribute to an IRA. If a person invested a refund in a tax-deferred account earning 8 percent annually, he or she could double his or her money in less than 10 years. There are several useful Web sites that can co this calculation for you.
And an IRA — particularly a Roth IRA — is a great way to do it. With a Roth, there isn't any sort of upfront tax break (like there is with a tax-deductible IRA), but qualified withdrawals taken after age 59 1/2 are completely tax free. Van Brunt and Marmon recommend giving up the deduction and going for the Roth — which is all yours for the rest of your life. You don't have to share it with anybody. And remember: There's still time to make a 2006 contribution (the deadline is April 17), as well as one for 2007. Unfortunately, not everyone qualifies for a Roth.
4) Pay off debt. These days, the average household with at least one credit card is carrying more than $9,200 in credit-card debt, according to CardWeb.com. Tackling high-interest credit-card debt is one of the smartest ways to use a tax refund, and doing so provides an immediate return on investment. (And most likely at rates that would be difficult to duplicate in today's stock market.)
5) Consider your children. If college costs continue to rise at their current pace, four years at a private college 18 years from now could cost more than $320,000. Needless to say, people with children need to start saving early. Using a refund to contribute to a 529 College Savings Plan or a Coverdell Education Savings Account is a great way to do it.
Both of these accounts offer tax-free withdrawals for qualified college costs. With a Coverdell Education Savings Account, annual contributions are limited to $2,000 (per beneficiary), and income limits do apply. The beauty of a Coverdell Education Savings Account, however, is that, like an IRA, the holder can invest funds as he or she sees fit.
A 529 college-savings program, on the other hand, has no income requirements, and parents can contribute up to $250,000 per beneficiary (although large contributions could have some gift-tax implications). The potential drawback is that parents are limited to the investment options provided by the plan, which typically total 10 or less.
RSS