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The Two Best Things to Do With Your Tax Refund

If you're going to receive a tax refund from the IRS — or already have — here's how to put it to work


As the Tax Day clock ticks down (don’t forget, you have until April 17 to file this year), it’s a good time to talk about what to do with your tax refund. Since more than 80 percent of federal income tax returns result in refunds, odds are yours will be one of them.
 
Instead of just plopping the refund into your bank account and blithely using it to pay bills or go on a spending spree, I’d like to suggest that you take a more purposeful approach this year.
 
There are two ways you can do this: Save the cash for the future, or use it to pay down your credit card debt. If you haven’t filed your return yet, you might want to fill out a special IRS form – Form 8888 – that can help you turn some or all of that tax refund into forced savings.
 
Saving Your Refund
 
Your tax refund could be an ideal way to find money for an emergency savings fund, the kind of rainy-day account that everyone should have, especially in today’s economy.
 
The National Endowment for Financial Education’s SmartAboutMoney.org site recommends setting aside an emergency fund that’s equal to three to six months of your daily living expenses.
 
If your emergency savings fund is covered, you might stash away your tax refund for retirement or another financial goal.
 
You could do this on your own, of course, by choosing somewhere to invest the refund. For 2012, the maximum IRA contribution is $6,000 if you’re 50 or older, and $5,000 if you’re not.
 
But IRS Form 8888 — its full name is Allocation of Refund (including Savings Bond Purchases) — can help you save some or all of your refund automatically. The form helps Americans take advantage of what J. Mark Iwry, deputy assistant secretary for retirement and health policy, called “savable moments” in The Wall Street Journal.
 
With Form 8888, you can instruct the IRS to direct-deposit part or all of your tax refund into an IRA for retirement: a traditional IRA, Roth IRA or SEP-IRA account (but not a SIMPLE IRA, which is for small businesses). The catch: You need to have that IRA account already, since the tax form asks for its account number.
 
You can also use Form 8888 to automatically deposit part or all of your refund to buy Treasury securities and savings bonds online if you have a TreasuryDirect account.
 
And, although the U.S. government generally stopped issuing paper U.S. savings bonds this year, it made an exception for people who want to buy paper savings bonds with their tax refunds. So far, sales of these tax-refund U.S. savings bonds are up 60 percent this year, according to The Wall Street Journal.
 
You can purchase up to $5,000 of paper, 30-year Series I Bonds with all or part of your tax refund; they’re called “I” bonds because their return includes inflation protection. The bonds currently yield 3.06 percent, although the government will reset the rate on May 1. They come in denominations of $50, $100, $200, $250 and $1,000. It takes up to three weeks to receive the bonds after the IRS processes your return.
 
You can even use your refund to buy savings bonds as gifts for your children or grandchildren.
 
Keep in mind that you generally can’t redeem I Bonds during the first 12 months after you buy them, and if you redeem the bonds within the first five years, you’ll forfeit the three most recent months’ interest. For more details about buying U.S. savings bonds, read the Next Avenue article "The New Rules for Buying and Giving Saving Bonds."
 
Using Your Tax Refund to Trim Debt
 
There's another smart way to go with your refund: Use it to whittle down your credit card debt. At a time when many credit cards sock customers with rates of 15 to 16.5 percent, that’s a painful levy worth trimming, if not eliminating.
 
If you have multiple credit cards, use your tax refund first to pay down the card with the highest interest rate. Maybe you’ll even be able to pay off that card entirely.
 
While looking for ways to cut your credit-card costs, you should consider switching to a low-rate card. At Bankrate.com, where you can compare cards, the average low-rate card charges 10.6 percent.

Just watch out for low-rate credit card offers that look too good to be true. Cards that lure you in with 0.00 percent interest often jack up their rates to double-digits after 12 or 18 months, and you typically need excellent credit — a credit score over 760 — to qualify for them.

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