Smart things to do with your tax refund

According to the most recent data released by the IRS, more than 48 million tax refunds have been issued so far this tax season. That's about 5.6 percent more than this time last year, and the average refund is up three percent at $3,034.

Given that the tax rates have increased and many popular deductions have been cut back, one would think that tax refunds would be down this year. But taking a closer look at the details, what seems to be driving the higher tax refunds is that more Americans are qualifying for a special tax credit. People with lower taxable income - unemployed, under-employed, etc - typically qualify for the Earned Income Tax Credit, which reduces their tax liability and often results in a tax refund.

Whatever the reason, a lot of taxpayers are getting some extra cash and will be thinking about what to do with it. Some will need to use this money to pay for essentials, like rent, food and gas. Others, when surveyed, said they plan to do something more virtuous with the money they get back from Uncle Sam, such as pay down debt or boost their savings.

Most tax refunds -- 88 percent according to the IRS -- are directly deposited into bank accounts, which is a smart thing to do. Retailers know that when people have extra money in their checking accounts, they can be tempted to do a little extra spending, such as splurging on shoes, clothes, or a nice dinner out. The longer it sits there, the greater the temptation.

If, however, your goal is to do something productive with your refund, there are plenty of ways of doing that. Here are some ideas, and suggested steps:

Move the money out of checking

To avoid the temptation to spend, before you do anything else, move the money out of your checking account and into another account where it's harder to dip into, such as a savings account, brokerage account, mutual fund, or retirement account.

Health spending accounts

One way to maximize your tax refund is by putting it towards your health savings account, or HSA. As more people enroll into health insurance plans with high deductibles, they become eligible to open and contribute to these accounts, which allow pretax contributions (the amount contributed is actually an above-the-line deduction on your tax return). Contributions grow tax deferred, and the withdrawals are used to pay for qualifying medical expenses tax free. The 2014 contributions limit for HSAs is $3,300 for individuals and $6.550 for families (folks age 55 and older can contribute an additional $1,000.) This is one of the best uses of a tax refund I can think of.

Pay down debt

Another great use of a tax refund is to pay down debt that charges a high interest rate. You'll save money by paying less interest and fees, and reduce the amount of debt you owe.

529 accounts

If you have children and are planning to set aside savings for their future education costs, then consider opening and contributing to a state sponsored college savings plan. Consider using a 529 education savings plan, where the money saved can be used tax free to pay for future college tuition. Many states also offer a deduction on your states income tax return if you contribute to your state plan.

401(k) increase

Increasing the contributions to your employer's 401(k) plan is another good move. Use the tax refund to make ends meet while the additional contributions are reducing your pay.

Make extra mortgage payments

Finally, think about making extra principal payments on your mortgage. By making just one additional payment on a 30 year mortgage each year, you can have the mortgage paid off in about 17 years and save thousands of dollars in interest over that time.
  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.