It’s that time of year again. Millions of Americans have begun receiving their tax refund checks. And these refunds seem to be burning holes in everyone’s pockets. Vacations are being booked… large-screen TVs are being bought… and a tattoo artist I know is working around the clock.
But this year, instead of taking a cruise or getting some new ink, why don’t you invest your refund toward your future?
For the 2018 filing season, the average federal refund is expected to be $2,840. But no matter how much you get back, this is a great opportunity to start investing. That’s because many of the online platforms that have sprung up in recent years are democratizing the investment process. No longer do you need thousands of dollars to open a brokerage account.
In another post, we’ve outlined our favorite services for investing when you don’t have much to begin with.
But here are five other ideas specifically for 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 a 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 is 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 to 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 a guaranteed rate of return of 11% on your investment each and every year the way you would on a certificate of deposit (CD) 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 there’s 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 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 program to expand your knowledge base or even obtain 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.
4. Pay Off a Small Debt or Two
It’s typical to think of a tax refund in terms of spending. But it can just as easily be used as a way to pay for past spending, aka debt.
A tax refund of $3,000 may not seem like a lot of money if you have a considerable amount of debt, but every little bit helps. A typical credit card has a monthly payment equal to 2% or more of the outstanding balance. So, by paying off some plastic, you could increase your cash flow by $60 per month, immediately and permanently.
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, you will 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?