Be smart about how you use tax refund

WASHINGTON -- For years I've been begging people not to use tax withholding as a forced savings tool.

I understand the reasoning. Times are tight and people want some financial security, even if it means letting the federal government keep their money out of fear they will waste it throughout the year.

But if you are going to continue just to get a tax refund, what should you do with it? For example, I received this question from a participant in a recent online discussion: "We're going to get a $7,500-plus tax refund. I'm not sure how that's possible, but I triple-checked our return. Should we use the refund to pay down our mortgage?"

Rather than discuss once again why getting a refund is not a good idea unless it is prompted by a change in your tax situation -- birth of a child, marriage, home purchase -- I want to talk about what to do with the money under certain circumstances.

Situation One: You have no emergency fund and lots of credit card debt.

In this case, set aside some of the refund and use the rest to pay off or pay down the credit card debt. Even when you are in debt, it's important to have some cash in reserve. Otherwise, if an unplanned expense arises, such as a car repair, you end up going further into debt.

Situation Two: You have some money put away for an emergency fund but not the recommended minimum of three months of living expenses. You have some credit card debt.

Let's say you've only managed to save about one month's worth of living expenses. You have $2,000 in outstanding credit card debt. Your tax refund will be about $2,000.

Don't worry about reaching the emergency fund target. You've got a good start. Pay off the credit card. With that debt gone, you can take the money you were paying for the debt (plus the interest) and continue building up your emergency fund.

Situation Three: You have more than enough in cash reserves and no other debt except a mortgage. That was the case with the reader who asked the question about a $7,500 tax refund.

Before paying down the mortgage, consider two more things. If you have children, you might want to boost their college funds or start one. Also, review your retirement savings to determine if you are on track.

If you have substantial savings and are meeting your savings and investment goals in other areas, then attack the mortgage. Generally, by making just one extra mortgage payment a year you will reduce a 30-year loan to about 22 years.

What I'm saying is if you're going to do a dumb thing and keep getting refunds unnecessarily, at least be smart about how you use the lump sum.

© 2008, The Washington Post Co.