WASHINGTON — Caroline Nielson already knows what she's doing with her federal income tax refund. Ms. Nielson, an employee of Amtrak, is using her refund check to pay for a dream trip with her sister to Paris this summer.
"I'm very responsible when it comes to money," she says. "But my refund check is a lot larger than in the past and it's a trip that we have been looking forward to for years."
If you're like Nielson, and the majority of America's 130 million taxpayers, a refund check from the Internal Revenue Service should soon be arriving in your mailbox. And this year, you should be getting a little extra money back from Uncle Sam.
Early refund statistics show that the average refund is up $97, or 4.5 percent from last year, to $2,292. Historically, about 77 percent of taxpayers get refunds. And many of them treat the windfall as "found money."
"There's a natural urge to want to just go out and blow it all, but I think people also have to think of ways to make that refund money work for them," says Steven Street, an accountant with Ross & Moncure in Alexandria, Va.
The decision about what to do with that refund check depends upon your individual financial position. But some recent research appears to indicate that most Americans are not just going out and buying plasma-screen TVs. Of those taxpayers who got early refund checks from President Bush's tax-relief bill in May, 18 percent put the money in the bank, 33 percent paid off bills, 20 percent spent it on everyday items, 15 percent paid off credit cards, and only 2 percent invested their money, according to a December 2003 survey by the Cambridge Consumer Credit Index.
With the April 15 deadline for filing tax returns looming, here are five ideas about how to make that refund check work for you.
With most credit-card interest rates at 14 percent and above, this can be one of the costliest items in your monthly budget. Reducing credit-card debt - or eliminating it altogether - can be one of the best financial decisions you can make, financial planners say. It may not be a glamorous way to spend your refund check, but it makes great financial sense in the long term.
"I tell my clients to pay off any high-interest debts first," says David Dondero, a certified financial planner in Alexandria, Va. "If you pay off a credit card with a 19 percent interest rate, it's like giving yourself a 19 percent return on your money. You can't go wrong by paying off a charge card."
A 401(k) plan could be one of the best investment vehicles a taxpayer can have. But all too often (as many fund plan managers will attest to) workers don't fund their plans sufficiently to earn all of their employers' match. The majority of this year's tax-law changes provided a boost to retirement savers. For example, starting in 2004, 401(k) participants can contribute up to $13,000 to their retirement nest eggs - an increase of $1,000 compared with 2003.
"If you simply put part of your refund into your 401(k), and have a match from an employer of 50 cents for each dollar you contribute, that's a terrific way to build a retirement nest egg," says Marc Freedman, a financial planner at TriCapital in North Bethesda, Md. "I'd say about 70 percent of my clients invest all or a good part of their tax refund."
Not everybody, of course, has an employer-sponsored retirement account at work. That's where other retirement plans like an Individual Retirement Account, a Roth IRA, a simplified employee pension plan (SEP), or a Keogh plan come into play.
"I advise a lot of my clients to put their tax return money in a Roth IRA for a simple reason - there's no guarantee that Social Security will be there for them when they retire," says Dixie Butler, a certified financial planner in McLean, Va. "If you have a $2,500 check coming your way, that just about fully funds your annual limit of contributions to a Roth."
Since 1997, investors have had two main types of IRAs from which to choose - a traditional IRA and a Roth. Both now allow a $3,000 individual contribution per year ($3,500 if you are 50 or older). But a Roth is taxed immediately and grows tax-free. Which type is right for you depends upon your situation.
Admittedly, paying for a college education is probably the furthest thing from your mind when that refund check arrives in your mailbox. But as the cost of college continues to rise, most investment advisers will advise their clients to start preparing as early as possible for funding this large family expense.
"If you don't have a 529 college savings plan set up, do it as soon as possible and start contributing immediately," says Ms. Butler. "It's a tax-free way to save for your child's college fund. You can even do it for your grandchildren's college fund."
Other options for college savings plans include your home state's college savings plan, a Coverdell education savings account, or US savings bonds.
With home prices continuing their upward trend all across the country, purchasing a home has proven to be a wise investment. And with interest rates hovering at or near historic lows, there may never be a better time to move out of an apartment and into a house.
"With some mortgage plans, all that's necessary to purchase a house is a good credit rating and 5 percent down," says Mr. Street, the accountant. "Your tax refund could actually go a long way to meeting that threshold. And that makes a lot more sense in the long term than blowing all your money on a big-screen TV."
If you already own a home, your refund can be used to improve your property. Even small investments such as painting the kitchen, adding new plants outdoors, or updating a bathroom can add value to your home.
Another real estate option is to increase your mortgage payment for the month, reducing interest on the loan and decreasing the overall amount you will owe in the long term.
While this is the last item on the list, it may prove to be the most rewarding. No matter what your interest or outlook, there's almost certainly a charitable group working in that field. Donations not only help others, but since they are tax deductible, you will also benefit when you do your taxes next year.