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The 6 best ways to use your tax refund

Eye on Money
What should you do with your tax refund check? 01:18

By Janna Herron/ValuePenguin

For many Americans, the big incentive to finish their taxes is a fat four-figure refund check from the Internal Revenue Service. This year, seven in 10 Americans will get a refund, according to the agency.

The big question is what will you do with Uncle Sam's check? Here are six possibilities.

Eliminate high-cost debt

Americans are carrying a record-high amount in credit card debt, which will only be harder to tackle as the Federal Reserve raises interest rates. Your tax refund may be a good way to wipe out, or at least substantially reduce your card balances. Consider this: The average U.S. tax refund for 2016 of $3,050, enough to eliminate some 55 percent of the average U.S. credit card balance—$5,551, according to a ValuePenguin analysis. Depending on the state, the average refund does even more—or less. For instance, it erases almost two-thirds of the average debt in North Dakota, but only chips away a little more than a third of the average balance in Alaska, ValuePenguin found.

If your tax refund doesn't erase all your debt, don't stop there, says Leon LaBrecque, managing partner of LJPR Financial Advisors in Troy, Michigan. "Don't wound a debt," he says. "Kill it."

If you have a good credit score, consider a balance transfer credit card that offers zero interest for a limited time to finish off the remaining balance. You avoid paying interest charges on the balance during that intro period, typically between 12 and 18 months, making it easier to pay off the debt.

Student and credit card debt: How to manage it 07:15

Establish a cushion

If you don't have enough money saved up to cover a car repair or a more dire event like job loss or medical emergency, put your tax refund toward that rainy day—after paying off high-cost debt. The ideal is to sock away six months of living expenses, including your mortgage or rental payment, car payment, debt payments and groceries.

But start with an easier goal of three months, before splitting any extra money between padding your emergency savings and increasing your retirement contributions. Put these just-in-case funds in an account that you can get to quickly without much hassle. Online savings accounts offer some of the highest yields among other savings accounts. These returns will also increase as the Federal Reserve raises rates.

Pad your retirement savings

There are three ways to use your tax refund toward improving your retirement security.

401(k) plans: You can't actually contribute a lump sum—like a tax refund—to your employer-sponsored 401(k) plan. But you can change your pre-tax contributions from your paycheck through your company's payroll. Divide your refund amount by the number of remaining pay periods left in the year to determine how much your contribution should increase for each paycheck. Ideally, you want to boost your contribution enough to get the full employer match, if one is available. Remember: You can contribute up to $18,500 for 2018.

IRAs: You can make contributions up to $5,500 this year total in your IRA accounts ($6,500 if you're 50 or older). Roth IRAs are available to those who meet certain income limits. Future withdrawals from Roth IRAs are tax-free. Anyone can put money in traditional IRAs and those contributions are fully or partially tax-deductible. Money in your traditional IRA, including earnings or gains, is taxed when withdrawn.

Health Savings Accounts (HSAs): HSAs are tax-advantaged savings accounts available if you have a high-deductible healthcare plans. These can also double as a retirement investment tool for future medical expenses in your golden years if you don't use the funds before. Individuals can contribute up to $3,450 this year; for families, the limit is $6,900. If you're over 55, you can add an extra $1,000 above the maximum. Contributions are tax deductible (if not made from pre-tax contributions from your paycheck), earn tax-free interest and provide tax-free withdrawals for qualified medical expenses. There are no age requirements for withdrawals.

Will your finances be ready for retirement? 02:47

Auto and student loans

Once you've maxed out your retirement accounts, turn to paying down auto loans and student loans. The average new car payment was $503 a month, according to Experian data from last year. Even if you don't save a lot in interest—since auto loan rates have been near historic lows in the past few years—you will free up a good chunk of change every month that can be used more wisely.

As for student loans, you'll likely save more on interest in the long term because some rates can go as high as 18 percent. But you'll free up some money each month, too, once you pay off the loan. The median student loan payment is $203. If your tax refund doesn't eliminate you entire student loan balance, it will still help to reduce your payback timeline, given you apply any extra funds to principal.

Future goals

529 plans: Get a jump on your child's college savings. These tax-advantaged savings plans are used to save for future college costs. Savings can also be used for tuition at private K-12 schools, up to $10,000, after changes implemented by the most recent tax reform bill. These plans are sponsored by states, and in some cases are tax deductible on state income taxes. Contribution limits vary by state.

A down payment: Beef up the money earmarked for buying a new home. If you can put down 20 percent (or more) toward the purchase of a new home, you can avoid having to pay for mortgage premium insurance every month, freeing that money up for other purposes.

Car purchase: If you plan to buy a new car, use your tax refund to get there. That way, you can avoid an auto loan—and a car payment that can easily run $500 a month.

A guide for first-time home buyers 04:36

Other investments

If you have all your other bases covered, you'll then have money you can invest—with a higher risk tolerance. Open a brokerage account and put your money to work in a no- or low-cost mutual funds or exchange-traded funds. If you're in a higher tax bracket, consider municipal bond funds, recommends Kristin Sullivan, a certified financial planner in Denver. "Target date funds are an easy solution for a diversified portfolio," she says. "Just pick the date when you think you may use the money."

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