Are You Overpaying Your Taxes?
But it's not too early to start thinking about next year, particularly if you have a hefty refund coming to you. I know—getting a burst of money at once is exciting, particularly in this down and out economy, but financially speaking, it's just not smart.
When you get a tax refund, you're giving the IRS a free loan for an entire year, a year that you could have had that cash stashed in an interest-baring account, where it would have been working for you, not Uncle Sam. Not only that, but this year, because of budget trouble, some states, including California and Kansas, have had delays getting refunds out. "In California, this went back to January, so filing early wouldn't have helped. Truthfully, this is speaks more to being careful in your withholding," says Sherrill Gregory, an enrolled agent in California.
The idea, of course, is to configure your withholding on your W-4 so that the amount that is withheld from your paycheck each month more or less matches your estimated tax liability. That way, come April 15 of the following year, you don't get a refund, but you also don't owe. A good way to run your numbers is by using the Withholding Calculator on the IRS website.
Even if you've been with the same employer for years, it's not too late to make a change, says Roni Deutch, author of The Tax Lady's Guide to Beating the IRS. "You can adjust your withholding any day of the year. But the longer you fail to adjust it, the longer you're going to be addicted to getting that refund check in April."
She's right, of course. You've come to count on that little windfall once a year, but wouldn't you rather have some extra each month to save for retirement, or pay down debt, or just make ends meet? So let's not put it off anymore. Tomorrow, when you go into work, go straight to your human resources manager (or your boss, if you work for a small company) and ask that he or she help you adjust your withholding. Then, stay on top of it, because many of life's milestones call for another look at your W-4, including marriage, divorce, a second job, birth of a child, the purchase of a home, capital gains and retirement.
The 3 best ways to spend your tax refund
As for this year, well, that refund is already on its way. So why not put it to good use? Here's how:
High-interest rate debt
If you have credit card debt, paying it off with this money is like an instant return on your investment: If you have a card with a 19 percent interest rate, for example, wiping that amount out is like earning 19 percent interest on the balance, because you won't have to pay it to the lender.
An emergency cushion
I've said it countless times before, but it bears repeating: Having a liquid emergency savings to fall back on is a necessity; even more so in this economy. You need at least six months' worth of expenses stashed away in a savings account, so if the unexpected comes along—you're laid off, your dog gets sick, your car needs major maintenance—you have money to cover the bills. That's how you stay out of credit card debt.
If you're covered in the first two areas, you can always use the extra money to boost your retirement savings. The average refund is about $2,500. If you invest all of it, you could have over $5,500 in 10 years; over $12,300 in 20; and over $27,000 in 30.
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