8 Smart Ways to Invest Your Tax Refund
Consider IRAs, College Savings, and Paying Off Debt
It's always nice to receive a tax refund. In the 2020 tax filing season (for 2019 taxes), the average tax refund was $2,616. Paying off credit cards or other debts, investing your return in the stock market, or placing it in your retirement fund are just some of the ways to use your tax refund.
Of all the options you have in front of you, the decision to use it to pay existing debts might be the best, but keep reading to learn more about the ways you can put your tax refund to work for you.
Pay off High-Interest-Rate Credit Card Debt
If you have any high-interest-rate credit card debt, paying it off should be your first “investment,” says Cynthia Meyer, a certified financial planner at Financial Finesse. That’s because the return on your money is equal to the interest rate—plus it’s guaranteed and risk-free.
If the interest rate on your credit card is 24%, for instance, then every dollar you put toward that debt is essentially seeing a return of 24%—much higher than you’d likely get in the market.
What about paying down your other debts, such as your student loans, your mortgage, or your car note? Pre-retirees might want to pay off their mortgage before they retire.
Consider whether your return will be better used to pay off credit debt or other debt. Interest rates on both federal student loans and mortgages are, on average, less than 10%. Each could also offer tax breaks. Paying down the debt that accrues the most interest would make the most sense, as it will reduce your overall payments.
Invest Against Future Expenses and Emergencies
“It’s not very sexy, but the next question to ask is: Do you have a nice emergency fund?” says Meyer. Ideally, you should save three to six months of living expenses in fairly liquid savings, but anything is better than nothing. If you don't have an emergency fund yet, stowing away your tax refund could save you from a world of hurt.
Having that amount of cash stashed in a savings account means you don’t have to put a new transmission or unexpected medical bill on a credit card. Returns on savings accounts are minimal, but that’s beside the point. An emergency fund's job is to be there when you need it.
Meet the Match on Your Workplace Retirement
It’s third on the list, but depending on your situation, this might be the best idea: take full advantage of any employer-matching dollars offered in a retirement plan by increasing the amount you’re contributing to your 401(k) or 403(b). If you have credit card debt to pay off and need to save for retirement, aim to do both if possible.
Tim Maurer, a financial adviser and author of Simple Money, says one way to free up additional funds for this (or any of the other options on this list) is to decrease your withholding.
Just make sure to increase your retirement contributions simultaneously so that you don’t squander the additional dollars in your paycheck.
Fund an HSA
If you have a high-deductible health plan with a Health Savings Account (HSA), you can park—or even better, invest—your dollars there. HSAs are triple tax-free: Money goes in pre-tax via a paycheck deduction (or, if you put it in yourself, it’s tax-deductible), it grows tax-free, and it’s not taxed upon withdrawal as long as you use it for medical expenses.
Passing money you use in the short-term through the account saves you roughly 25% on all your medical costs. You can also invest the money in the account and allow it to grow. Once you hit age 65, withdrawals not used for health care are treated just like 401(k) withdrawals and taxed at your current income tax rate.
The contribution limits for these accounts are $3,550 for individuals and $7,100 for families in 2020. In 2021, these figures increase to $3,600 and $7,200, respectively.
“If you haven’t maxed out your HSA contributions for the year, you can increase your payroll contribution and invest it in a broad stock market fund . . . it’s even better than a Roth IRA because it’s pre-tax and tax-free growth.”
Contribute to an IRA
If you’re already meeting the match on your workplace retirement plan (or don’t have one), an IRA is the next step on the road to retirement readiness.
You receive an upfront tax deduction on the money you put into a traditional IRA. It grows tax-deferred, but you pay income tax when you begin taking withdrawals (which you can do starting at age 59 1/2 and must do at age 72). With a Roth IRA, there’s no tax deduction today—but when you tap the account in retirement, it's tax-free.
“The Roth [IRA] generally makes sense if you think you’re going to be in the same tax bracket or higher in retirement.”
There are also no required withdrawals with a Roth, which means you can pass the funds to your heirs, and there’s more flexibility. In many cases, you can withdraw the money without penalty to pay for a child's college or to pay off your home.
Buy Into the Stock Market
If you have your retirement funding squared away, and you’d like to do something with your refund that has the potential to give you back more than you put in, consider purchasing stocks or mutual funds.
Historically, the market has delivered better returns than savings accounts and Treasury bonds. However, the market can be volatile, and returns are never guaranteed.
Trying to time the market is risky, and stock prices can fluctuate. Most financial advisors recommend against investing in the stock market when saving for short-term goals. However, they do recommend investing when saving for long-term goals like retirement.
You can invest in individual stocks or mutual funds, which are bundles of stocks, through a broker or a robo-advisor. Robo-advisors offer low-cost investing options for do-it-yourself investors.
Keep in mind that your investments are not protected by the Federal Deposit Insurance Corporation (FDIC) like checking and savings accounts are. If the stock market drops, you could lose money.
Parents who are looking to invest in their child’s future education might want to consider a 529 college savings plan. Similar to Roth IRAs, you contribute after-tax money, and your dollars grow tax-free. As long as you use the money for education, you won't owe taxes. In some states, you may even get a tax break for your contributions.
But here’s the most important caveat, according to Maurer:
“You cannot put your long-term financial security at risk for the sake of your children’s college . . . if all of the other boxes are checked for long-term retirement planning, then, by all means, utilize a 529 savings plan.”
Make a Donation
Another way to invest is by making a charitable contribution—and you can manage your donations like you would your investment portfolio. If you want your money to have the greatest returns or the biggest impact, then you have to focus less on the charities that make you feel good and more on the ones that do good.
Before donating, ask the charity's representative questions such as, “For every dollar, how do you spend it?” and “How is the world changing because of your charity?” There are many charitable organizations that are worth considering. In addition to asking questions directly to representatives, you could use a third-party nonprofit reviewer to research a few that you're interested in before picking the one with the best impact.