Have you thought about what you’re going to do with your tax refund? The average tax refund in 2016 is in the neighborhood of $3,053, $5 more than last year. That’s not exactly a life-changing amount, but it’s a decent chunk of change that can jumpstart an investment or savings goal.
A lot of people choose to spend their refunds on things that will bring pleasure, such as a family vacation, new furniture or even the down payment on a car.
But we’re going to suggest you instead put the money toward something that will provide additional financial benefits, especially those of a long-term variety.
Here are five ways to invest or save your tax refund.
1. Create a Tax Deduction for Next Year
This is a way of using your tax refund to create yet another refund for next year. If you’re in the 35% combined marginal tax bracket (say, 28% for federal and 7% for your state), you can create a $1,050 refund for next year by putting a $3,000 refund into a tax sheltered traditional IRA account now.
This will be a way of compiling your tax refund for next year before we’re even halfway through the year. Anything you add on top of this will be a bonus.
In addition, the money in your IRA will grow on a tax-deferred basis. And you can invest it in a way that will allow it to grow many times your initial investment, particularly if you are investing it for decades. See below.
2. Invest in an S&P 500 Index Fund
Going back to 1950, the S&P 500 index has provided an average annual rate of return on the order of 11%, including dividends. If you invest your refund — say $3,000 — in an index fund, such as the Vanguard 500 Index Fund ETF Shares (VOO), an 11% annual return could turn your small investment into $24,187 in 20 years, just with that $3,000. That’s an eightfold increase in your investment.
This doesn’t mean you’ll earn 11% on your investment each and every year the way you would on a guaranteed investment like a certificate of deposit or a Treasury bond. But you can fully expect to see that as an average effective rate over a period of decades.
And one of the best features of an index fund is that it’s both low cost and tax efficient. Since index funds are based on the underlying index, they trade only in response to changes in the index itself. That means very little in the way of transaction costs. And for the same reason, the funds don’t produce much in the way of taxable capital gains income. They simply grow and grow not entirely unlike a tax sheltered retirement plan.
3. Invest in the Energy Sector
If you’re looking to invest in an undervalued sector, energy could be the place. Not long ago, oil prices were around $100 a barrel; today they’re less than half that. The energy sector in general has taken a beating as a result, but that just sets up a buying opportunity that could pay off handsomely later.
If you have other money invested in more predictable asset classes, you might want to take a chance investing your refund in energy while prices are low. This is an opportunity to buy low and sell high later when energy prices recover. And since energy is a primary sector, you can bet prices will not only return to more typical levels, but they’re likely to have a spike or two that will take them higher, even into record territory.
Your tax refund can provide you with an opportunity to get in while energy stock prices are low. In the next few years, it’s possible this sector could outperform the general market.
4. Invest in Your Career or Business
Though we normally think of investing as putting money into traditional investments such as stocks, mutual funds or real estate, often the best investments are the ones you make in yourself. If you have been wanting to take a course or a program to expand your knowledge base or even provide you with a much-needed certificate or credential, your tax refund can provide you with the cash to do it.
Similarly, if you have a business and there’s a certain piece of equipment you need to invest in that will increase your productivity, your tax refund could be the source of much-needed capital.
Either investment could be a step that enables you to take your career or business to the next level and increase your earned income going forward. That’s one of the best investments you could possibly make.
5. Pay Off a Small Debt or Two
Though it’s typical to think of a tax refund in terms of spending, it can just as easily be used as a way to pay for past spending, a.k.a. debt.
A tax refund of $3,000 may not seem like a lot of money if you have a considerable amount of debt, but as a typical credit card has a monthly payment equal to 2% or more of the outstanding balance, you could increase your cash flow by $60 per month immediately and permanently by paying off some plastic.
And let’s say you have a car loan that has a remaining balance of $6,000, with 12 payments left. By paying $3,000 toward the balance, you may not be able to pay off the loan but you will be able to cut the remaining term in half. So even if it won’t bring immediate relief on your car payment, it will bring it within a few months.
Think carefully about what you will do with your tax refund. You could certainly spend it on having a good time, but you could just as easily spend in areas that will improve your financial situation, and sometimes for many years to come.
Readers: Did you receive a tax refund this year? How are you planning to invest the funds?