Dear Carrie: I get a big tax refund every year. Is it better to invest it, pay off debt or save it for a rainy day? --A Reader
Dear Reader: Your question certainly hits three of the top ways to make the best use of any extra cash. Which to focus on first -- investing, debt reduction or savings -- depends a lot on your overall financial picture, and I'm happy to give you some guidelines. But before we get into how to prioritize where to put your money, I think you need to look at your tax situation and determine if you're managing your withholding properly.
REVIEW YOUR WITHHOLDING
When you start a new job, your employer has you fill out a W-4 form, which helps the employer figure out how much federal income tax to withhold from your paycheck. On this form, you claim a certain number of withholding allowances. The more allowances you claim, the less income tax will be withheld from your paycheck. If you're getting a big tax refund every year, chances are you've claimed too few allowances on your W-4.
While you might view a big refund as a good thing, there's another way to look at it. By having too much withheld, you're reducing your take-home pay and in effect, giving Uncle Sam an interest-free loan with money that could be in your own pocket each month.
MAKE A CHANGE IN YOUR W-4 IF NECESSARY
If you'd rather have that extra money in your paycheck, all you have to do is complete a new W-4 and submit it to your employer. The withholding calculator at IRS.gov can help you determine how many allowances to claim for your current situation. To use the calculator, it's best to have your most recent pay stubs and income tax return handy. Once you have the new information, you can download a W-4 from the IRS website. And you don't have to wait until the end of a tax year to make a change. You can give the new W-4 to your employer at any time. You might also want to run this new scenario by your tax advisor.
GET DOWN TO FUNDAMENTALS
Whether or not you decide to make a change in your future withholding, you're smart to be thinking about where best to put your money to work. While you mention three important categories, I'm going to add a fourth and actually make it No. 1 on my list of suggested priorities. I consider all of them fundamental to good money management.
1) Focus on your future by making sure you're contributing enough to your 401(k) to capture any company match. You might consider this an extra bonus beyond your tax refund.