Put your tax refund to good use
By Greg McBride, CFA • Bankrate.com

It is that time of year when taxpayers nationwide uncover for themselves, or find out from their tax preparers, the answers to two important questions: "Am I getting money back?" and "How much?" For those receiving a payment from the U.S. Treasury, thoughts inevitably turn to various purchases or extravagances that are now within reach. Tempting as they may be, it pays to consider some other methods for putting a tax refund to good use.

Consumer debt burdens continue to grow, and interest rates will inevitably rise. Alan Greenspan doesn't seem to think it is such a big deal, as noted in a speech Feb. 23. But to many households burdened by debt, it is a big deal. Receiving a tax refund is an excellent opportunity to make a dent in that debt.

Begin by applying the tax refund, and any other cash you can scrounge together, to the highest interest rate obligation. Most often, this is credit card debt. A cardholder carrying $9,000 in credit card debt at 13 percent and paying $300 per month is five months closer to a zero balance by applying a $1,000 tax refund payment today. In addition to saving five months of debt payments, the cardholder saves more than $450 in interest costs. Not a bad return on that $1,000, is it? If you're looking for a better return for the money without risk, don't bother. Dispatching of high-cost debt is a guaranteed, risk-free return, the likes of which cannot be found in financial markets. Looking for a debt-repayment plan for other obligations? Use Bankrate's Debt-Paydown Adviser.

Perhaps you're fortunate enough to be debt-free, or have recently become debt-free, and are determined not to be a servant to debt in the future. A tax refund then becomes a golden opportunity to pad an emergency savings fund, especially if day-to-day expenses make this difficult.

It may be tempting to give the cold shoulder to an emergency savings fund with interest rates so low, as yields of 2 percent or less may be unappealing. But don't dismiss the importance of having access to accumulated savings. Consider instead the scenario of owing additional taxes for 2003. Enter the emergency savings fund, which serves as a buffer from incurring debt to meet unexpected financial demands. Instead of thinking of it as an asset that earns barely enough to keep pace with inflation, think of it as a shield from incurring debt at 13 percent or more in the event of unexpected financial circumstances. An adequate emergency fund is enough to cover at least three months, and up to six months, of expenses.

After repaying debt and establishing a sufficient emergency savings cushion, a tax refund can also be a much-needed boost to retirement savings. Taking the tax refund proceeds and making an IRA contribution is a good start, but it doesn't end there. After receiving a tax refund, it makes sense to adjust how much tax is withheld from your paycheck to better align with your present circumstances. This alleviates a big refund next year -- and an interest-free loan to Uncle Sam in the interim -- while increasing take-home pay now. In the absence of debt or the need to increase liquid savings, the additional take-home pay can be used to boost retirement contributions to a 401(k) or the equivalent. Further, this is accomplished without cutting back on current lifestyle.

A tax refund isn't an ideal windfall to receive every year, but if applied efficiently, is a one-time bonus that can pay repeated dividends.

Greg McBride is a financial analyst for Bankrate.com.

For advice regarding your specific situation, please e-mail one of Bankrate.com's Q&A experts or visit the Personal Finance Advice channel on Bankrate.com.