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Hefty tax refund could end up costing you

Many taxpayers think that getting a federal refund is a big deal. They look forward to it all year.

It’s the largest lump sum lots of people receive, according to the American Tax and Financial Center at TurboTax, the tax software company.

Last year, the average federal tax refund was about $2,800, about $100 less than in 2011, according to the Internal Revenue Service. In 2010, the average refund was about $3,000, which works out to about $250 a month.

Typically, you pay your federal taxes by having a portion withheld from your pay. If too much is withheld, you get a refund. But guess what? In order to get that lump sum, you lent your money to the government with no interest.

Still, a majority of respondents in an online poll said they intentionally have too much money withheld from their pay so that they can receive that refund, according to the National Foundation for Credit Counseling, which conducted the survey.

“Many people say that they can’t find a way to consistently save other than to short themselves through their payroll withholding,” said Gail Cunningham, spokeswoman for the NFCC. “That is indeed forced saving in the truest sense of the word.”

When it comes to what to do with the refund, most people do the smart thing – they use it to pay down debt or put it away for other uses. For others, it’s the little extra they need to stretch their paychecks at the beginning of the year. Forty-two percent of taxpayers who file their returns early use the funds to cover rent, food and utilities, the TurboTax survey found.

I’ve encouraged people to quit relying on a tax refund. Yet the lesson seems lost on so many. Many intentionally get a refund because they don’t feel they are disciplined enough to save on their own. And if the alternative is that you won’t save, then go ahead and do what works for you. At least you’re putting that refund to good use when you get it.

But consider this. Your forced savings plan may be costing more than you realize.

We know that many folks live paycheck to paycheck, which often means not having enough to cover all their expenses. Some bills go unpaid or are paid late. Or perhaps you are making only the minimum payment on your credit cards because there aren’t any extra funds to pay them down faster.

“Why continue in this financially self-defeating cycle when a solution is so readily available?” Cunningham asks.

“An incredible amount of damage is done to credit reports and scores each month due to consumers not being able to pay at least the minimum amount due, or paying it late,” she said. “And that’s not even counting the amount of interest and late fees tacked on to existing balances.”