3 ways to use your tax refund

By Walter Updegrave, senior editor

(Money Magazine) -- Question: I'm trying to figure out what to do with my $500 tax refund. I'm looking to save for the long-term rather than waste it on a TV. Any suggestions? -- Chez, Colorado Springs

Answer: Ah, tax refund time. For many people this is the largest single chunk of change outside their paycheck that they'll get their hands on all year. You've got half a grand, but many people expect much more. According to a recent survey by Completetax.com, taxpayers anticipate getting an average tax refund of $2,800 this tax season from the feds alone.

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).

Not too long ago, before the stock market headed south and the housing bubble popped, many people saw a check from the IRS as an opportunity to indulge themselves a bit. Take a little vacation, buy a new electronic gadget, maybe splurge on a dinner at that fancy restaurant with the big prices and tiny entrees.

And even if someone expressed a desire to invest his tax lucre back then, chances are they wanted to do something adventurous with it, like put it into a house or condo with the idea of flipping it for a fast profit.

My, how times have changed. Even though the stock market has climbed by more than 50% over the past 12 months, the disappointment of the housing collapse and the shock of the 2008 market meltdown still linger, making most of us, shall we say, more circumspect about how we spend and invest.

So given this more cautious attitude what should you -- or, for that matter, someone with an even bigger refund coming his way from the IRS -- consider doing with a tax windfall?

Here are three suggestions:

1. Build (or rebuild) your emergency fund.

If nothing else, the experience of the past two years reinforces the value of having an emergency fund to fall back on. Whether it's a pink slip at work, the loss of income from investments, or just an unexpected expense popping up at an inconvenient time, keeping three to six months' worth of expenses tucked away in a highly secure place can give you financial wiggle room that could mean the difference between being able to meet your obligations or having to scramble to stay afloat.

So if you depleted your emergency reserve during the recession, a tax refund can be an excellent way to begin rebuilding it -- or give you a jumpstart on a new cash cushion if you didn't have one before.

Remember, though, this is money that you absolutely, positively want to be able to count on when you need it. So you don't want to take any risks with it. Which means you should stick to highly stable investments such as insured savings accounts, short-term CDs, or high-quality money-market funds.

Granted, these options are paying minuscule yields of 1% to 2% at the moment (actually less in the case of money-market funds). But as über-investor Warren Buffett told Berkshire Hathaway investors this year in his shareholders letter when explaining why he keeps upwards of $20 billion in cash equivalent assets that pay only a pittance: "We sleep well."

2. Repay high-interest debt.

If you've already got some money tucked away as a buffer against hard times, there's a way to enhance your financial security while also effectively earning an attractive rate of return: Use your tax refund to pare down debt that carries a high interest rate.

Credit cards are a prime candidate. Let's say, for example, someone expecting the average $2,800 tax refund has exactly that much outstanding on a credit card that charges a 16% annual rate and requires a minimum payment of 4% of the balance. If that person makes only the minimum payment, it will take 105 months to pay off the card.

But applying the $2,800 tax refund to the account would wipe out the balance immediately and save $1,297 in interest. The money that would have gone to principal and interest payments each month could then be invested (as opposed to spent).

Clearly, the amount of interest savings and freed-up cash will vary depending on the size of your tax refund, the interest rate you're paying and how much of your refund you devote to wiping out debt.

3. Invest it.

If you've set up an emergency fund and have made a dent in your credit-card or other high-interest debt, you can then think about investing your tax refund.

Question is: what's the right way to go about this?

Many articles will rattle off a list of stocks or mutual funds that are supposed to have the best return potential at the moment. More often than not, that's just an invitation to get into hot investments that are ready to cool.

I contend you're better off thinking about why you're investing -- whether it's accumulating a down payment for a house, paying a child's college tuition, building a retirement fund or for some other reasons -- and then deciding how your refund fits into an investment strategy appropriate for reaching that goal.

In most cases, that means thinking not in terms of one investment -- a stock, a bond, a mutual fund -- but creating a mix of stocks, bonds or mutual funds that's appropriate given the amount of time you have to invest. If you already have a diversified portfolio, then you can divvy up your refund among the investments you already own. If you're dealing with a relatively small amount of money where splitting the refund in several pieces is impractical, you can plow it into whatever part of your portfolio is lagging, giving you a head start on rebalancing.

If you don't have a diversified portfolio, it's time to think about building one. And for the names of specific stock and bond mutual funds that you might consider,see our Money 70 list of recommended mutual funds and EFTs.

The idea, though, is that you don't want to just throw this money into whatever investment the nattering nabobs of the investing world are babbling about today. You want it to fit into a coherent investing strategy.

Of course, unless you're talking about one helluva big check, your tax refund alone isn't likely to dramatically change your financial future. But if you follow up with regular saving and smart investing, your refund may be able to help put you on the road to financial security -- or keep you moving ahead on that path if you're already on it. To top of page

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