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Investing your tax refund is a fantastic way to start building wealth.
If you received a tax refund from Uncle Sam this year, you shouldn't celebrate just yet. Aside from the fact that it was your money to begin with (not a friendly gift from the government), you may need to make some adjustments before next tax season begins.
If you have too much withheld from your paycheck, you're essentially lending your money to the government for free. What's worse is that you're missing out on the time when your money could be growing for you. If this is the case, be sure to adjust your federal withholdings or check your W-4 again.
That's not to say that getting a lump sum of cash from the government doesn't make you feel good. However, don't get caught treating your refund differently than your paycheck. Your money is valuable and just like your paycheck, every dollar of your refund should serve a purpose.
Last year in 2023, the average tax refund payment was more than $2,753, according to the IRS. If you're one of the people who received a tax refund this year, first consider some ways you can make the money work for you before wasting your tax refund on a vacation or another big deal.
Here are some suggestions for what you can do with your tax refund:
Table of contents
1. Contribute to your emergency fund2. Pay off your debts3. Save more for retirement and other goals4. Refinance your mortgage or make home improvements5. Invest in a taxable account6. Donate to charity7. Start your own business. Bonus: Change your withholdings to avoid receiving a refund. Final thoughts
1. Contribute to your emergency fund
Have you thought about what would happen if you were unexpectedly laid off or faced a large unexpected expense? If you are unprepared for this or a host of other misfortunes, you should consider withholding your tax refund.
It is recommended to have at least a few months of easily accessible cash for “rainy days.” Although some financial experts say six months to a year of emergency cash is necessary. However, the extent to which you save for an emergency largely depends on your situation.
Putting some (or all) of your tax refund into a savings account as an emergency fund can be a smart way to build wealth. This is probably the easiest way to start investing your tax refund. The best high-yield savings accounts currently pay interest rates of over 5%!
Read our complete guide to emergency funds here.
2. Pay off your debts
Possibly worse than an unexpected emergency is a current emergency, also known as debt.
If you're one of the many Americans facing high-interest debt, you should focus on cutting spending and putting every spare dollar toward your debt. Additionally, it is often recommended to pay off debt before even starting an emergency fund (we disagree, but you shouldn't shy away from paying off debt anyway).
The logic behind this is that if you are already in debt and depleting your emergency fund, you will no longer have the financial ability to borrow money. Borrowing money using a credit card is never an attractive option, but it may be necessary in difficult situations.
According to the latest data from Forbes, the average credit card APR is 27.92%. Yikes!
Here's an example of why you should pay off this debt. Let's say you have $2,753 in credit card debt with an APR of 27.92%. If you only make the minimum payment of $200 per month, it would take you 1 year and 5 months and pay an additional $603.97 in interest on that amount. If you were to claim your tax refund and pay it off, you would avoid all the additional interest – saving you $600! Now you no longer have a credit card balance – and can start investing in other areas of your financial life!
Note: If you have student loan debt, this could be the case now NOT Be the best time to pay them back (due to loan forgiveness programs and more). Instead, focus on other debts like credit cards or car debt.
3. Save more for retirement and other goals
If your financial house is in order, you've accumulated a healthy emergency fund, and you're debt-free, another option for your tax refund is to invest it.
The average American does not set aside enough money for retirement. Many financial advisors recommend investing 10 to 15% of your annual income toward retirement, but of course, given the time value of money, the sooner you invest, the better.
If you started investing late, it's never too late to close the gap. A tax refund of $2,753 will certainly help you get closer to your goals. In fact, this amount would be half of what you can contribute to your IRA this year.
Let's break down what investing your tax refund would look like. If you invested $2,753 at an average return of 9% (which is actually slightly below the S&P 500's historical average) and never added any more money, you would have:
- After 20 years: $15,428.94
- After 30 years: $36,525.92
This is the power of compound interest! And if you invest your tax refund in your retirement account, that money could even be tax-free in the future!
4. Refinance your mortgage or make home improvements
Mortgage rates are at an all-time low. If you are financially prepared and ready to buy, there really is no better time. If you already own a home, you can take advantage of these interest rates by refinancing and paying your closing costs and fees with your refund. This means you can immediately save money on interest payments.
If you're really ambitious, you can continue paying the same monthly mortgage amount and reduce principal debt. Additionally, if you've been putting off an expensive project, now might be the perfect time to cross it off the list. Home improvement projects are a great way to increase the value of your home, and the benefits are usually noticeable right away.
Related: The Best Places to Refinance Your Mortgage Online
5. Invest in a taxable account
If you've already maxed out your tax-deferred accounts, you're definitely ahead of the game and probably don't need to listen to this advice. Opening a brokerage account can be a great way to further diversify your portfolio and let your money grow for you.
Since these investments are fully taxable, it may be a good idea to switch to low-cost investments or tax-efficient mutual funds or ETFs.
A taxable account works just like a retirement account – you have your investment portfolio of stocks and bonds. The only difference is that these are not tax-deferred.
6. Donate to charity
Depending on who you are, this could be number one on your list. For others on a tight budget, giving to charity can be difficult. A tax refund is a way to contribute to a charity of your choice.
A charitable donation may not provide a return in the form of dividends or capital gains, but sometimes the benefits a donation can bring are more valuable than anything money can buy. Not to mention, you can deduct charitable donations from your taxes.
7. Start your own business
If you have a business idea that you've been putting off, a refund might be just the thing you need to get things started. This is a great way to see the return on your investment and your small business can also qualify for tax deductions.
If you don't know where to start, we have a list of the 15 best online business ideas that you can start right at home.
Bonus: Change your withholdings to avoid receiving a refund
One option you may not be thinking about is to simply change your tax withholdings from your paycheck so that you don't get a refund but rather a debt. This may seem crazy, but remember, a tax refund is just a refund of Extra money You have paid the tax authority throughout the year. It's your money!
Changing the W4 withholdings on your paycheck will give you larger paychecks all year long. Then at tax time you would pay the difference you owe. This is something most savvy investors and high net worth individuals do. Never let the IRS get extra money that belongs to you.
The only downside here: You must plan to write a check to the IRS in April. If you don't save or don't have the money, you could get into trouble. So before you start adjusting your withholding, make sure you have a plan.
Final thoughts
Regardless of how much refund you receive, a tax refund, if you receive a refund at all, should be treated with the same value as any other dollar you earned. If nothing else, it should be treated added valueas you are basically being paid for the work you have done throughout the year.
Whether your refund was expected or not, it should be used in the way that is most beneficial for your particular stage of life. As tempting as it is to treat yourself to something you desire, just like all of your hard-earned money, investing in something that will move you forward toward your goals is far greater than any item you could purchase at the mall .
What other investment ideas do you have for your tax refund?
Editor: Claire Tak
Reviewed by: Ashley Barnett
The post 7 Ideas for Investing Your Tax Refund to Get the Most Out of It appeared first on The College Investor.
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