Did you get a tax refund this year? Maybe you got a couple of thousand dollars from the IRS, and you’re wondering how you can best invest it? It is easy to feel like your tax refund is ‘free money’, but it’s important to think about how you can best use your tax refund to better your financial health.
What’s the average tax refund for 2022?
The average tax refund this year is $3,012 as of May 5, according to the IRS. This is an important source of income for many households and it’s a great opportunity to pay off debt and get closer towards your financial goals.
What are some smart ways that I can invest my tax refund money?
We are going to share 4 tips that we believe are the best ways that you can use your tax refund money. Please think about your personal situation and decide which approach may be best for you.
TIP #1: Buy I Bonds?
Consider using your tax refund to buy I Bonds. I Bonds are savings bonds that are 100% backed by the federal government. I Bond rates are tied to inflation which is why they are called I Bonds. Recently, inflation has been surging. The current rate on I Bonds, as of May 2022, is 9.62%. This is the highest it has ever been. The maximum amount of I Bonds that you can purchase is $10,000 per person per year. If you receive $15,000 for your tax refund then you will have to find another use for the extra $5,000. The $10,000 that you invest is locked in for 12 months. It’s like a certificate of deposit (CD). You can purchase I Bonds at TreasuryDirect.gov.
TIP #2: Invest in an index fund?
Another smart way to invest your tax refund is by purchasing a low-fee index fund. Warren Buffett is currently the 5th richest man in the world and is my investment idol. He has instructed the trust for his wife when he dies, to invest in just one low-fee index fund. Instead of picking stocks, one of the world’s smartest investor is advising us to keep it simple.
Therefore, you may want to consider investing your income tax refund in a low-fee index fund. Time and time again, studies have shown that more than 80% of high-cost mutual funds underperform. Whether they are funds in the US, Europe, Latin America or Australia, the odds are against you if you invest in high-fee mutual funds.
If you invested your $10,000 tax refund in a fund that charges 1.2%, and its investments grow by 6% per year over 40 years, that fund will collect close to $40,000 in fees from you. However, if you invested in a low-fee index fund that charges only 0.2%, makes the same underlying return, you would make $32,000 more because of the lower fees you’ll pay. If you would like to learn more about index funds, check out our blog about ‘Fidelity Index Funds For Beginners’
TIP #3: Invest in a Roth IRA?
If I’ve convinced you to invest your tax refund money in an index fund, you might ask, should I just invest that in a brokerage account? Let’s say you got a $2,000 tax refund. You invest it smartly, and it becomes $10,000. Do you want to pay taxes on the $8,000 that you made? That’s what will happen if you buy an index fund in a brokerage account. If you make that investment inside a Roth IRA, then all of the money you can make from your tax refund money will be tax free.
People often make mistakes when investing in a Roth IRA. The most common one is contributing to a Roth when you’re no longer eligible. To make sure you don’t make mistakes, check out our blog on 3 common mistakes with Roth IRAs. If you’re no longer eligible for a Roth, don’t despair, there is a loophole that exists. This loophole strategy is called a Backdoor Roth.
TIP 4: Pay off high-interest rate debt first
Before you even think about investing your tax refund, pause for a second and ask yourself: “Do I have any outstanding credit card debt or personal loan?” If you do then most likely it’s charging you 8-12% if it’s a personal loan, or 20+% if it’s credit card debt. You can “make more money” if you pay those off first. Basically, instead of the credit card company earning 25% on you, you’re capturing that money back by paying it off.
There are two approaches that you can use to pay off high-interest rate debt first if you can’t pay it all off at once.
- Avalanche method: focus on paying off the highest interest rate debt first. Once you have paid that debt off, then start paying off the second highest interest rate debt and then keep going with this sequence until all of your debt is paid off. This method will save you the most money.
- Snowball method: pay the smallest debt off first and then work your way up until all of your debt is paid. This can be a great method if you are someone who is motivated by accomplishing specific steps towards your goal.
What is the smartest thing to do with tax refund?
The smartest thing to do with a tax refund is this:
1) Use your tax refund to pay off any credit card debt or personal loan.
2) If you’re done with #1, use your tax refund to add to your emergency fund. If you do, you may want to put your tax refund in an online savings account for higher interest.
3) If you already have 3 to 6 months in emergency money, ask yourself, do I have any big purchases coming up? If you’re planning to buy a car in a few months, then set your tax refund aside for your car purchase.
4) Do you feel like giving part of it to charity? If so, you can select a charity to give part of your refund. If you give to a 501(c)(3) charity, your donation is tax-deductible!
5) If none of the first four apply to you, you can think about investing your tax refund in stocks, bonds, or alternative assets. Consider using low-cost index funds when investing your tax refund.
Use your 2022 tax refund wisely
Don’t feel like you have to put all of your tax refund towards one specific thing. It can be split across various approaches. We have given you several options on how to use your tax refund wisely. If your debt is paid off, you may also want to treat yourself to a much needed vacation with your family. Health is wealth and sometimes a reset is what is needed to better yourself and keep pushing towards your financial goals. Make your money work for you and enjoy your tax refund.