Mellody Hobson: What to Do With Your Big Refund

March 22, 2006 — -- According to a recent USA Today analysis of Internal Revenue Service records, taxpayers overpaid their federal income taxes by 29 percent in both 2003 and 2004. Basically, many taxpayers are having nearly twice the amount of the traditional safety margin withheld from their paychecks to avoid having to pay a tax bill, but it could be costing them money.

This additional withholding translates into $10 billion annually, or roughly $100 per tax return. The overpayment trend seems to have continued in 2005, as tax refunds are currently up approximately 4 percent from 2004 -- the average 2005 tax refund is about $2,400 to date.

Why are refunds bigger this year?

It is important to keep in mind that average tax refund amounts tend to be higher earlier in the tax season because the taxpayers who expect a refund file early to get their money faster. That said, there were some new tax changes in 2005 that may contribute to the larger refunds.

For example, the child tax credit, which was supposed to revert to $700 in 2005 (from $1,000 in 2004), was extended through 2010. The amount will remain at $1,000 for each qualifying child, assuming you are within the required income thresholds.

Individuals living in states without income taxes also benefited in 2005: Taxpayers who itemize deductions will have a choice of claiming a state and local tax deduction for either sales or income taxes on their 2005 returns. Additionally, parents and students may be eligible for higher deductions and credits for 2005 tuition and fees.

Isn't getting a bigger refund a good thing?

No, a bigger refund is not necessarily better. Getting a refund means you overpaid throughout the course of the tax year, which essentially translates into loaning money to the government interest-free.

Over-withholding is growing the fastest among families earning $50,000 or less each year, because they tend to benefit the most from tax credits. Oftentimes, these are the families that need the money the most and end up paying $100 or more to obtain a refund-anticipation loan to get this overpayment back sooner. So, while some may believe this "forced" savings is a good thing, it may actually cost you more money than you think.

So, is there anything you can do to better ensure you pay the right amount of taxes?

When you start a new job, you complete a W-4 for income tax withholding purposes. Unfortunately, this is the last time many people think about their withholding. While changes in tax rates will automatically adjust your withholding, changes in tax deductions and credits will not. So, as the years go by and personal situations as well as tax laws change, many people end up paying more than they should.

To avoid overpayment, it is important to revisit your withholding annually. When preparing your taxes each spring, you should also take the time to assess your financial situation for the current calendar year to determine if any changes need to be made to your withholding. If so, contact your employer to complete a new W-4. Many people will actually need to submit a new W-4 almost annually. Several things can change the amount of withholding allowances you elect on your W-4, including child care costs, tuition, alimony, the birth or adoption of a child and medical expenses. So it is important to evaluate your situation each year to ensure you pay the right amount in taxes.

If you do get a big refund this year, what should you do with it?

Although overpaying your taxes and getting a refund is not a recommended way to save, if you are getting a bigger-than-expected refund, put the money to work for you. First and foremost, you should reduce any outstanding debt. Also, consider investing the money in an IRA for yourself or in an education savings account on behalf of a child. Whatever you do, do not put the money toward a frivolous expense that you ultimately cannot afford.

If you use a tax preparer to file your taxes, do you need to worry about your personal information being shared with outside parties?

Currently, your personal data remains private and the only people with access to it are you, the IRS and a tax preparer (if you use one) -- but that may be changing.

The IRS is considering revising its rules regarding usage and disclosure of taxpayer information -- specifically Section 7216 of the tax code -- to permit tax preparers to sell personal information to outside third parties. Why the change? The rules are being changed to allow for increasing use of electronic-filing systems.

Right now, tax preparers can use your information to offer you other related services, but under the new proposed rules, they could sell your information to a third party data broker who could use your financial information to target a variety of products to you. As such, it is important to stay tuned regarding the final outcome on these new rules and always read all paperwork carefully before signing on with a tax preparer to make sure you understand how and with whom your information will be shared.

Mellody Hobson, president of Ariel Capital Management in Chicago (www.arielmutualfunds.com) is "Good Morning America's" personal finance expert.