Editorial Policy

Should I Pay off Card Debt with My Tax Refund?

Erica Sandberg

January 15, 2013

QDear Erica,

Would you advise we pay off our credit card balances with our tax return? We are getting almost $8,000 back from federal and state. Or should we put it in savings instead? Right now we do not have anything in savings because we had some upsets last year. We owe about $6,000 on two separate credit cards. We also have a car loan and a lease, but they are cheap. — Maurice

AHi Maurice,

Naturally, you want to do the right thing with the big refund that you are about to receive! And paying down debt makes sense. When it's gone, so are your monthly payments, leaving you with more cash to spend on other bills and deposit into savings. Better yet, any interest fees that you're currently being assessed on rolled-over credit card balances will cease, so you'll stop wasting money on excess charges.Ask Erica

Then again, the decision of just how to distribute all that money is not always so simple. You have at least two types of liabilities and nothing stashed away for emergencies. At least a little in savings is recommended. You depleted the account for some unexpected expenses, and I'd rather you not leave it empty for too long.

So what, exactly, should you do with your hefty refund? Here's my five-step plan.

1. Send $5,000 to your credit card companies. Whichever card has the highest interest rate should get the bulk, and add the rest to the other. That will leave you still owing a grand or so, and I'd like you to pay that off within a few months.

2. Deposit $3,000 to your hollowed-out savings account. Such a substantial sum would make just about anyone feel more secure. Will it guarantee that you'll have enough to pay for every crisis? No. But it's a great start, and that kind of deposit has emotional weight.

Make a commitment to not touching the savings account unless you absolutely must, and add to it regularly. Ten percent of your monthly net income is a good, solid figure to work with. For example, if you bring home $3,000, have $300 automatically siphoned over to the account. Once you have accumulated three to six months' of necessary living expenses, you can save for the more fun things in life, like a vacation and items you'd like for the home.

3. Reroute your debt payments to car payments. I'd love for you to be in the clear with your car loan as soon as you can. Once you're free of credit card debt, you can send what you were giving the card companies to the bank or finance company that's holding your car note.

4. Tweak your tax withholdings. That $8,000 isn't lottery winnings. It's what you overpaid on your taxes. Imagine how your life might have been different last year if you had that extra $650 in your checking account each month ($8,000 divided by 12 months). I bet that you would have been able to pay bills more easily, not used your credit cards as much and maybe even not have had to tap your savings account as much. Talk to a tax adviser about how you can minimize the amount that is returned to you at the end of the year.

5. Examine your spending habits. You've got two cars (one loan and one lease) that you're paying for, and you're carrying credit card debt. Something is amiss. Pare down your expenses so you can at least break even. Or add to your income so you can maintain your lifestyle. Whatever works.

Check in with me again this time next year. If you follow my plan, I bet you'll be in far better financial shape!

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