In 2014, the average tax refund was about $2,700. If you got that much this year, what would you do with it?
You can probably think of a lot of things you might do with $2,700. You might decide to splurge and buy some big-ticket item you’ve been eyeing. Or you could use the money to pay down some bills, which might be a good idea, especially if it helps improve your cash flow. As an alternative, though, you might want to consider investing the money.
You might not think $2,700 would make that big a difference to your investment portfolio. But if you invested that $2,700 in a tax-advantaged account, such as an IRA, and you left the money alone, what might you earn? After 30 years, your $2,700 would have grown to more than $20,500, assuming no further contributions and a hypothetical 7% annual return. That’s not a fortune, of course, but it would help boost your retirement savings somewhat — and since it originated from a tax refund, it was accumulated pretty effortlessly from your point of view.
Now suppose you put in the same amount — $2,700 — to your IRA each year for 30 years. Again assuming that same hypothetical 7% annual return, your money would have grown to more than $272,000. And that amount can indeed make a rather big difference in your retirement lifestyle.
Keep in mind that you’d eventually have to pay taxes on that $272,000 if you had been investing in a traditional IRA, which is tax-deferred but not tax-free. It is possible, however, that if you start taking withdrawals when you retire, you’ll be in a lower tax bracket.
If you meet the income guidelines for contributing to a Roth IRA, though, you could avoid the tax issue altogether on your $272,000. That’s because Roth IRA earnings grow tax-free, provided you don’t start withdrawals until you’re 59½ and you’ve had your account for at least five years.
Thus far, we’ve only talked about putting your tax refund to work in your IRA — which, as we’ve seen, can be a very good idea. But suppose you’ve already developed the excellent habit of “maxing out” on your IRA each year by contributing a set amount each month? You can currently only put in up to $5,500 per year to your IRA, or $6,500 if you’re 50 or older. So you could fully fund your IRA by putting in about $458 per month (or $541 per month if you’re 50 or older). Those amounts are not unreasonable, especially as you move deeper into your career and your salary increases. If you do reach these limits each month, what could you do with your tax refund?
You can start by looking closely at your portfolio to see if any gaps exist. Could you, for example, use your tax refund to further diversify your holdings? While diversification can’t guarantee profits or prevent losses, it can reduce the impact of volatility on your portfolio — and the less you feel the effects of volatility, the more likely you may be to stick with your long-term strategy rather than overreacting to short-term price drops.
So when Uncle Sam sends you that refund, consider investing it one way or another. You’ll be putting it to good use.