8 Smart Ways to Invest Your Tax Refund
Consider IRAs, College Savings, and Paying off Debt
So you got yourself a nice tax refund (or it's on its way), and you’ve decided to take the opportunity to invest it. Good idea. In 2019, the average tax refund was $2,729. Investing that money in the market could be one smart move, or you can use it to support your retirement or other financial goals.
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 get the mortgage paid off before they retire, but because the bang for your buck will be less (interest rates on federal student loans are about 5% to 7%, mortgages are 3% to 4%, and both are tax-deductible), you’ll want to weigh the return against other possibilities.
“It’s not very sexy, but the next question to ask is: Do you have a nice emergency fund?” says Meyer. Ideally, you’ll want to save three to six months of living expenses in fairly liquid savings, but your refund itself—at about $3,000—can save you from a world of hurt. Having that amount of cash stashed in a savings account means you don’t have to put that new transmission or unexpected medical bill on your credit card. Returns on savings and money market accounts are minimal, but that’s beside the point. An emergency stash’s job is to be there when you need it.
It’s third on the list, but this might be the one investment you can make that beats that credit card interest rate return: Grab any employer-matching dollars offered in a retirement plan by increasing the amount you’re contributing to your 401(k) or 403(k). (If you have credit card debt 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 money 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 fritter away the extra 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 into them pretax 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. That means passing money you use in the short-term through the account saves you roughly 25% on all your medical costs. But 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. “If you haven’t maxed out your HSA contributions for the year [the contribution limit is $3,500 for individuals and $7,000 for families in 2019], you can increase your payroll contribution and invest it in a broad stock market fund,” says Meyer. “It’s even better than a Roth IRA because it’s pretax and tax-free growth.”
If you’re already meeting the match on your workplace retirement plan—or don’t have one—an IRA is the next stop on the road to retirement readiness. But do you want a Roth IRA or a traditional one?
Here’s the difference: You receive a tax deduction on the money you put into a traditional IRA. It grows tax-deferred, but you pay income tax when you pull the money out (which you can do starting at age 59 1/2 and must do at age 70 1/2). With a Roth IRA, there’s no tax deduction today—but when you tap the account in retirement, you tap it 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,” says Meyer.
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 get the money without penalty, including to pay for college or to buy your first home.
So, your retirement is squared away and you’d like to do something with your refund that has the opportunity to pay off big: Consider investing in the stock market. Over time, the market has delivered better returns than savings accounts and Treasury bonds. However, the market can be volatile, and returns are never guaranteed.
Since 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 DIYers.
But 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 risk losing 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.
But here’s the most important caveat: “You cannot put your long-term financial security at risk for the sake of your children’s college,” says Maurer. But “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 in someone (or something) else 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 $1, how do you spend it?” and “How is the world changing because of your charity?” Givewell.org, a nonprofit that offers research and analysis on charities, can help you answer these questions, too.