5 Smartest Ways to Spend Your Tax Refund

You're getting money back. Now make it work for you

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Getting a tax refund can seem a bit like winning a small lottery. In 2012, more than 120 million taxpayers got $322.7 billion in refunds, according to the Internal Revenue Service. That worked out to an average of $2,860 per person.

A refund can be tempting to spend -- in fact, one-third of Americans planned to shop with their 2013 refund, according to a Capital One Bank survey. Of those, 30 percent are putting it toward everyday expenses; 23 percent, a vacation; and 15 percent, electronics. But there are ways to use that money that can improve your financial situation now and for the future.

It’s a good idea to have six to nine months’ worth of expenses set aside for unforeseen emergencies.

Lule Demmissie of TD Ameritrade

Pay Down Debts

If you’re past due on an account, the best use of refund money is to make payments and get back in good standing, says Gail Cunningham, the vice president of membership for the National Foundation for Credit Counseling. Then, pay down high-interest debt.

This would seem to be a good idea since the average household had $7,122 in credit card debt according to January 2013 figures from the Federal Reserve. Yet only 37 percent of those surveyed by American Express said they would use a refund to pay down debts.

Paying off credit cards with typical interest rates effectively makes an investment that returns 20 percent or more per year, says Kevin Gallegos, the vice president of Phoenix operations for Freedom Financial Network. He says you should start with the cards with the highest rates or the lowest balances.

Invest in Yourself

You can invest in yourself by improving your job skills or seizing new opportunities, says Steve Siebold, author of the 2010 book “How Rich People Think.” Business seminars, workshops, and coaching and mentoring programs can all help. If those work-education expenses add up to 2 percent or more of your adjusted gross income for 2013, they may even qualify as an itemized deduction.

You could go more formal and take a college class or two. A refund of nearly $3,000 “represents a good part of the cost of an associate's degree,” Gallegos said. That, in turn, can lead to tax credits for next year. The Lifetime Learning Credit offers up to $2,000 for an unlimited number of years, while the American Opportunity Credit awards up to $2,500 per year for up to four years.

Boost Emergency Savings

An American Express survey found that 26 percent of consumers plan to save their refund in 2013. That's up from 22 percent from 2012.

“It’s a good idea to have six to nine months’ worth of expenses set aside for unforeseen emergencies,” said Lule Demmissie, the managing director of retirement at TD Ameritrade.

Most people don’t follow that advice. In fact, only 25 percent have six months of savings according to Bankrate.com.

Having a financial safety net in place might help with a one-time issue like an unexpected car repair. It could even keep you afloat if you're laid off and must hunt for a new job. Cunningham says you should keep the money in a savings account or other liquid investment for easy access.

Fund Future Goals

Today's tax windfall might be tomorrow's savings if it funds a child’s education or your retirement. Contributions to a traditional individual retirement account may be deductible on your 2013 taxes, Demmissie said. That doesn't count for Roth IRAs, but the extra money will help it grow and can be withdrawn tax-free once you reach retirement age. The maximum contribution for 2013 is $5,500, or $6,500 if you’re 50 or older.

When it comes to education, some 529s and Coverdells have tax benefits depending on what state you live in, Demmissie says. Both have tax-free withdrawals as long as the money goes to qualified education expenses. The IRS caps Coverdell contributions at $2,000 per year, and 529 plans at $13,000.

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Improve Your Home

If you own your home, a refund could pay for needed maintenance, Gallegos says. That could head off bigger and more expensive problems in the future.

“These capital improvements also can sometimes create additional equity,” Gallegos said.

There are also tax credits if you complete energy-efficient improvements before the end of 2013. A refund could pay for such a project, and you could get up to $500 back next year. Adding qualifying windows and doors, for example, is worth a credit or 10 percent of the cost up to $200. New insulation is worth 10 percent of the cost, up to $500.

Lessening a Refund

A refund isn’t the lucky windfall it initially appears to be. You're just getting back money you lent the government for the year; if you'd instead put that money into a savings account or invested it, you might have earned some extra money. A big refund can also indicate that something is awry.

Evaluate your withholding. Ask your employer for the necessary form, a W-4, to have less tax money withheld from your paycheck. That will increase your paycheck and reduce your refund, says Kevin Gallegos, a vice president for the Freedom Financial Network.

Check your work. The Internal Revenue Service sent out nearly 5 million “math error” notices to taxpayers in 2011 over their 2010 returns. A bigger than expected refund could be a sign you incorrectly calculated something along the way, particularly if you filled your form out by hand.

Talk to a pro. A tax preparer or financial adviser can help you figure out how to meet financial goals year round while minimizing tax obligations, said Melissa Labant, the director of taxation for the American Institute for Certified Public Accountants. Then, if you still get a refund, you may be in good enough financial shape to spend it.

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