What to do with your tax refund

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

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NEW YORK (Money) -- Question: What do you think is the best way for someone to use his tax refund money this year? --Stuart Levy, Chelmsford, Mass.

Answer: If you believe the recent Newsweek issue that has Uncle Sam on the cover exclaiming "I Want You To Start Spending!" and a story inside with the headline "Stop Saving Now!", then I guess it's your patriotic duty to go on a shopping spree with your tax refund, assuming it's arrived. (If it hasn't, you can track it on the IRS web site.)

Hey, I consider myself as patriotic as the next guy. But, frankly, I think the idea that you should base your personal financial decisions on what may or may not be good for the economy overall (assuming you can even know that) is just plain dumb.

So if you're one of the nearly 48 million households that the IRS says will get an average refund of just over $2,700, I say you should decide what to do with it based on what makes the most sense for you and your family, not some misguided notion of patriotism or economic altruism.

But here are some suggestions.

Start or add to your emergency fund. It's always a good idea to have three to six months of living expenses tucked away in a secure stash like a bank account, short-term CDs or a high-quality money-market fund to serve as a cushion against financial setbacks. And given the rate at which economy has been shedding jobs in this recession, such a reserve is especially crucial.

Of course, if you've managed to avoid the chopping block up to this point, you may figure you'll be able to hang on until the recovery begins. Don't be so sure. After the 2001 recession officially ended, the economy still lost another 1.4 million jobs.

So if you haven't already set up an emergency fund, consider using your tax refund to create one, or expand the one you have if it's not large enough to sustain you for a reasonable period.

Repay debt. Did you run up credit-card, home-equity or other debt during the boom years? If so, your tax refund may provide a relatively painless way to eliminate or reduce what you owe. One big benefit to whittling down debt is the interest savings: credit cards are charging 14% annual interest on average these days.

And in addition to hefty interest charges, credit card companies and banks looking for ways to boost income in the face of this recession have also begun raising late fees and other charges.

Congress is working on legislation to curb fees and interest rates and the White House economic advisor Lawrence Summers says the Obama administration also plans to address credit card abuses. Whether or not these efforts will actually help consumers is an open question. In the meantime, your best shot at paring interest charges, avoiding fees and adding more wiggle room to your budget may be to apply at least some of your refund to outstanding loan balances.

Contribute to a retirement account. If your 401(k)'s balance has shrunk, your tax refund may allow you to restore at least some of its value - and grab some tax benefits as well. Probably the easiest way to do that is to use your refund to open up a traditional or Roth IRA account, assuming you qualify.

Alternatively, you could boost the percentage of pay you contribute to your 401(k) to reflect the extra bucks you'll have with the refund. If you don't have a 401(k) and have already maxed out your IRA, you can always just invest the refund in a taxable account and mitigate the tax bite on any gains by sticking to tax-efficient investment options like tax-managed funds and index funds.

Oh, and assuming you meet the eligibility criteria, you might also qualify for a Savers Tax Credit of up to $1,000 ($2,000 for a joint return) on top of the regular tax breaks you get from contributing to an IRA or 401(k), effectively allowing you to parlay your tax refund into another tax goodie.

Invest in yourself. Higher education certainly doesn't immunize you against the possibility of a job loss. But, as these unemployment figures comparing workers with and without college experience show, the more education you have, generally the better your chances of remaining employed (not to mention earn more over your lifetime).

So you might want to consider using your refund to pay for courses at a local college or to otherwise boost your marketability and job skills. You might also qualify for a tax break under the recently revamped and renamed Hope education credit (now the American Opportunity Tax Credit) or the Lifetime Learning Credit.

At the very least you may be able to deduct the cost of a class that maintains or improves skills needed in your present work as an unreimbursed work-related expense in the miscellaneous itemized deduction category.

Buy something you can really use - that might also get you a tax break. The last thing I want to do is encourage spending for its own sake. But there may be instances in which your needs nicely dovetail with some recent tax incentives.

For example, if you've been thinking of replacing a home water heater, installing new windows or investing in alternative energy systems like solar or geothermal heat pumps, doing so now might snag you one of the enhanced energy-conservation credits that are part of the giant stimulus package president Obama signed in February.

If you need to replace a beat-up car, you may be able to cash in on a new sales tax deduction for new cars (and motorcycles). Or, if your refund is really big and you've been considering new digs, you could consider putting your refund toward the purchase of a first home and possibly qualify for a tax credit of up to $8,000.

But whatever you do with your refund - whether you spend it, save it, invest it, use it to repay debt or give it to charity - do it because you believe that's the right move for you and your family.

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