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How a Tax-Refund Windfall Can Hurt Your Finances

Richard Satran
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What could be wrong about getting a $3,000 check in the mail?

It's great news if you're like most Americans who have been strapped for cash. The average refund is just under that amount, surveys say. But millions of people use their refund in a way that virtually assures they'll have less cash in the future than they might have had--and for some, the money can be misspent and become a negative.

Studies of consumer behavior show that people spend money very differently depending on how it is acquired. In a well-known "windfall" study from 1994 at University of Michigan, students who earned money the hard way, pouring tar for a summer job, spent it at the same rate as suntanned lifeguards who spent their days toiling at the beach. But cash from "windfalls" like tax refunds or other kinds of "found" money were sometimes spent twice as fast as earned money.

[Read: Good News, Bad News for Tax Refunds.]

For many Americans, the tax refund is the year's biggest money event, and they often use it to pay for vacations and big-ticket items because it is outside of the salary pool. It's fine to live a little, but people are living a lot longer and it's good to think about the value of money over time.

"Some people think of it as a lottery win," says tax lawyer Genilde Guerra, managing partner at Kravitz & Guerra in Hallandale Beach, Fla., who gives tax advice to many non-residents who come to this country to work. "People who move here from abroad are not used to the tax-refund system. I tell them to spend it on something good, toward a house, paying down debt, retirement. Not like everyday salary."

"It can be a negative," she adds. Some people awaiting their tax refund actually go deeper in debt as they anticipate the check in the mail and then spend the money and forget about repaying it later.

Then there is the "lost opportunity" cost to consider. For example, if you took that $3,000 and spent it all on a trip to Jamaica, you would have a lovely week of palm trees and beaches, and a week later, it will be over except for the sunburn.

Putting that amount aside in an Individual Retirement Account (IRA) would give you an immediate deduction that could reclaim as much as $1,000 in tax savings--and you still would have your original three grand. If you put it into a dividend fund or other IRA investment that pays just 5 percent, you will have a total of $6,000 in 14 years and $12,000 in just under 30 years.

[Read: How the IRS Tracks Your Digital Footprints.]

You've just treated yourself to an extra $9,000, not to mention the fact that your original $3,000 is still there to help cover tax on withdrawals--and you've already gotten a tax break of perhaps another $1,000, depending on your tax rate at the outset. You can go out and spend that.

Despite the fact that most people are not even close to funding their retirements, many pass up on the chance to do so when those big checks arrive. Nearly one-third of the people who get a refund will spend it on vacations and purchases, according to an American Express survey. Cars are a big item, says eBay, which found in a poll that one-third of consumers will use at least a portion of their refund on cars or car fix-ups.

What should you do? Tax refunds represent "one of the best chances a lot of people will get all year" to repair their finances, says David Batchelder, chief investment officer at Measured Wealth Private Client Group LLC in New Hampshire.

Tax-refund recipients would be wise to avoid the siren call of the mall or costly vacation destinations and keep working to get their finances in order. Batchelder has his own "shopping list" of the three smartest things to do with that annual refund check. None involve strolls to the mall. They include:

1. Pay down high-interest rate debt. "That's No. 1 on my list for anyone who is getting a refund," says Batchelder. It could be like gaining a double-digit return on your investment. That's hard to beat in this low-rate environment.

2. Fund your retirement account. "Time is running out to fund this year's accounts," says Batchelder. But even if you get a refund after April 15, he says, you can still take advantage of tax-deferred savings on your IRA for the entire year, and the allowance rises $500 for 2013. The tax deduction of up to $5,500 for 2013 (or $6,500 if you are over the age of 50) can be taken in the following tax year.

3. Fund an emergency savings account. Putting aside your tax refund in an emergency account can help tide you over should a job loss or unexpected expense occur. The Employee Benefit Research Institute reports that only half of workers say they could definitely come up with $2,000 if an unexpected need arose within the next month. Financial planners say a rule of thumb is to have six months of expenses covered by an emergency fund.

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Many people are refraining from splurges, according to the American Express survey that showed more than half of people are still saving and paying down debt in a "recession mentality," said Melanie Backs, spokesperson for Amex. Backs sees a silver lining in this year's defense-minded personal finance playbook. As things get better, "people are feeling more confident," she said. But even as the recession fades to memory, they are resisting the urge to overspend at the expense of financial security. "They learned some valuable lessons," Backs said.

Still, nearly everyone has the urge to splurge, says Batchelder. If you do want to stroll the mall, avoid the travel agent and big-ticket purchases. His sage advice at that point: "Go get an ice cream cone. That won't mess up your future."

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