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taxes

How to Put Your Tax Refund to Good Use

Consider these five smart ways to spend the money.

I’m anxiously awaiting my tax refund. Do you have any suggestions for smart ways to use this annual windfall?

Extra cash is still hard to come by, so it’s important to start thinking about good uses for your tax-refund money before the check comes in. The following strategies can stretch your refund and help improve your financial situation for the rest of the year -- and even longer.

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Pay down high-interest credit-card debt. Credit-card interest rates continue to be high, and paying off high-interest cards should be a top priority -- after you stop having to pay so much money in interest every month, you’ll have more cash to devote to the rest of your financial goals. Paying off high-interest cards can be one of the best investments you can make right now -- using your refund to pay off a balance with an 18% interest rate is like earning 18% on your investments. See Kiplinger’s What Will It Take to Pay Off My Balance? and The True Cost of Paying the Minimum calculators to see how much money you can save in interest by boosting your payments, and how long it will take to pay off the entire debt.

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Build up your emergency fund. It’s essential to have extra cash on hand so you don’t land in high-interest debt when you have unexpected expenses. Many folks who relied on a home-equity line of credit as an emergency fund in the past must find another source of money as housing values shrink and lenders cut back on credit lines. Try to keep at least six months’ worth of essential expenses in an easily accessible money-market account or savings account; keep the money separate from your regular checking account so that you aren’t tempted to raid the funds for everyday expenses. Your tax refund can be a great source of extra cash to bolster your emergency fund -- or refill it, if you had to tap the money during the tough economic times over the past few years. See our How Much Should I Set Aside for Emergencies? calculator for help deciding how much money to keep in the account.

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Save for retirement. You have until April 18, 2011, to contribute up to $5,000 to an IRA for 2010 (or $6,000 if age 50 or older by the end of 2010). If your modified adjusted gross income is $122,000 or less if you’re single, or $177,000 or less if you’re married filing jointly, then you can contribute to a Roth IRA for 2010, which lets you withdraw the money tax-free in retirement. See Get the Most Out of Your Retirement Accounts for more information about the Roth contribution and income limits for 2010 and 2011.

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But even if you earn too much for a Roth, you can still contribute to a nondeductible traditional IRA, then immediately convert it to a Roth. See Back Door to a Roth IRA for more information. And if you’ve already made your 2010 contribution, you can use your refund to start making 2011 contributions and add more money throughout the year (the contribution limits are the same for 2011 as they were in 2010).

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Save for your kids’ college. If you have your retirement savings under control, consider funneling your tax refund into your kids’ (or grandkids’) college fund. Money in a 529 account can be used tax-free for college costs, and you may even get a state income-tax break for your contribution. See Give the Gift of a 529 Plan Contribution for more information about the tax breaks, and The Top College Savings Plans for our favorite 529 plans.

Help your kids open a Roth IRA. For the biggest future bang-for-your-buck, use your refund money to help your kids open a Roth IRA. The money can grow tax-free for decades, and they can withdraw the contributions at any time without penalties or taxes. There’s no minimum age requirement for opening a Roth, but your child must have earned income to qualify. They can contribute up to the amount of their earned income for the year or $5,000, whichever is lower. See Roth IRAs for Kids for more information about the rules for kids’ IRAs and which fund companies and brokerage firms offer good deals.

SEE OUR SLIDE SHOW for more smart ways to use your refund.

Finally, even though it might seem nice to get a refund, it actually means that you were giving the government an interest-free loan for the year. Use our tax withholding calculator to determine whether you can adjust your tax withholding and get more money in every paycheck starting right away. See How to Adjust Your Tax Withholding for more information.

For more information about filing your 2010 taxes, see Ready, Set, File: The IRS Awaits and our tax tips column.

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