There's never been a better — or easier — time to start investing. That's because online platforms are democratizing the investment process. Only recently, you'd have needed thousands of dollars to open a brokerage account… and even more for fees. However, these new services require low to no minimums, and many have relatively minuscule fees or are completely free to use! So let's dive in and check out where to invest tax refund.
Best Ways to Invest 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. 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 park it in that IRA for decades.
You can open an IRA with a robo advisor such as Betterment or Wealthfront (Full comparison here). Both services are our recommended “go-tos” for safely investing for your future. Fees at both services are low, and you can get started with only a $500 minimum (Wealthfront) or even $0 (Betterment). Here's a quick comparison between the two:
|Minimum to Open Account||$0||$500|
|Advice Options||Automated, Human Assisted||Automated|
|Socially Responsible Investing|
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
Although 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 (corny, but true). 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.
5. Tuck It Away in a High-Yield Savings Account
Competition among online banks is fierce, and that's great news for your money. Because many of these financial institutions have cut down on the costs of owning hundreds of brick-and-mortar branches, they're able to pay you much more in interest. That makes saving your money for a rainy day a whole lot brighter.
Putting your money in a U.S.-based savings account can be a particularly smart idea because most of these accounts are insured by the FDIC up to $250,000. So even if your bank were to go belly up, your money would still be protected to that amount.
Most of the banks we've reviewed offer high-yield savings accounts. Ally Bank (sister to Ally Invest), in particular, shines. It's got zero fees, no required minimum deposit, and an interest rate north of 2.00%.
Money market accounts can also be a great savings vehicle. They require higher account minimums and larger initial deposits that the typical traditional savings accounts, but in return, they usually offer higher interest payouts. For example, if you can invest $10,000, you can earn 2.00% with a Capital One 360 money market account.
And let's not forget certificates of deposit (CDs). They may require you to park your money away for a prescribed period of time, but they can be among the highest-paying accounts. Right now, a five-year CD with Barclays will generate more than 3.00% in interest. (Check out all the best rates here.)
6. Create an Emergency Fund
I'm no “prepper,” storing away gallons of distilled water and stashing gold under my mattress. But I understand that sometimes emergencies catch us unaware.
From car breakdowns to job losses, to (heaven forbid) medical emergencies, it pays to be prepared. And unfortunately, many American's aren't.
According to a recent study, only 40% of U.S. citizens have enough money saved to cover a $1,000 emergency. That's frightening.
A good rule of thumb is that you should have three months' worth of income in your emergency fund. However, every little bit counts. Putting your tax refund into a high-yield savings or investment account and earmarking it for the proverbial rainy day could be a life-saver.
7. Give Back With Your Investing Choices
Finally, what better way to invest than in a way that gives back? That's the idea behind socially responsible investing (SRI), a strategy that chooses investments that help make the world a better place. We're talking about stocks in everything from environmentally friendly companies to companies that actively work for humanitarian causes.
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.