As tax preparation season approaches, it makes financial sense to ask yourself what's the best way to use any federal tax refund you may have coming. Or, do you even want a refund?
[ibd-display-video id=2881940 width=50 float=left autostart=true]After all, money in a refund constitutes an interest-free loan to the U.S. Treasury. If you're giving those free loans to Uncle Sam year after year, you're committing a financial error. You can break that costly cycle by reducing or eliminating your excess tax withholding. And we can point out ways to use that money for yourself.
Refunds typically are not humongous, but they certainly tend to be much more than mere pocket change. And they've crept up in size recently.
This year through Sept. 1, the latest date for which the IRS has released data, the average U.S. refund was $2,782. That was up from $2,750 in the same period last year, although slightly down from 2016's year-end average of $2,860. Since 2009, the average refund for an individual's return has been about $2,840.
Here are steps you can take to trim or eliminate your refund:
- Submit a new Form W-4. Read your pay stub. By lowering the number of allowances, you reduce the amount of money withheld from each paycheck. After filling in a new form, submit it to your employer for processing.
- Adjust your quarterly estimated payments. This is for people like consultants or contractors, who have non-W-2 income from which no taxes are withheld. It has the same effect as adjusting allowances on a Form W-4.
But if you adjust your estimated payments, do not end up paying too little. If you end up with an underpayment, that can make you liable for IRS penalties, warns Doug Amis, president and chief operating officer of Cardinal Retirement Planning in Cary, N.C. After you reduce your estimated payment, be ready to reverse course by boosting your payments if your income rises.
How To Invest Your Tax Refund
In addition, here are five financially smart things you can do with a refund once you do receive it. The first three are ways to make a profit. The fourth - funding a health savings account - is also a way to make money while coping with medical expenses. The fifth step - donating to charity - is financially beneficial because it can lead to a tax deduction, but it's also a way to do well by doing good.
- Contribute to a traditional or Roth IRA. This is in addition to any money you put into your workplace retirement plan. In 2017 and again in 2018, you can kick in up to $5,500, or up to $6,500 if you are age 50 or older. Those contribution caps are in addition to whatever you may contribute to a 401(k) account. If you are covered by a workplace plan, your eligibility to deduct your IRA contribution depends on your income.
- Pay off credit-card balances and any high-interest-rate loans . "This is a great trade-off to put more money back into your accounts by" reducing or ending your high-interest costs, said Joe Berry, an investment advisor representative with Semmax Financial Group in Greensboro, N.C. Or use the money to pay down your student loans.
- Fund an emergency savings account. This simple action can help you avoid having to use credit cards, which have high interest rates, to pay for unexpected medical bills or repairs to your home or vehicle, Berry says. Over time, aim for a balance big enough to cover at least six months of living expenses, says Mike Loewengart, vice president of investment strategy for E-Trade Financial ( ETFC ).
- Fund a health savings account (HSA) . You can do this if you have a high-deductible health plan (HDHP). Contributions are tax deductible. Earnings grow tax-free. Withdrawals for eligible medical expenses are also tax-free.
- Donate to charity. For those who are charitably inclined, your philanthropy can make the difference in the life of someone less fortunate than you, Cardinal Retirement's Amis says. "If you are itemizing, this could be an additional deduction for the next tax year," he said.