What Should You Do With Your Income Tax Refund?
This spring and summer, nearly 100 million Americans will receive a federal income tax refund averaging $2,716, which is about four percent less than the average refund that was received last year ($2,822), according to statistics complied by the IRS. Many people view their tax refund as the ultimate financial windfall—kind of like a “gift” from the government every year.
Some people have big plans for their refund, whether it’s spending it on a summer vacation, a new car or boat, a big-screen TV, or some other electronic “toy.” Of course, everyone is entitled to decide how they want to spend their money, and to the degree that items like this are bought with a tax refund instead of on credit, they may be wise purchases.
But have you considered the potential benefits of saving and investing your tax refund instead of spending it, or using your tax refund to pay down debt? Decisions like these may prove to be more financially beneficial over the long term than spending the money now—even if it’s on something you really want.
For example, suppose you receive the average federal income tax refund of about $2,700 this year. If you invest the money, instead of spending it, and earn a 6 percent average annual return (compounded monthly) over the next 30 years, the money will grow to $16,331 in 2042—not a bad long-term return on your investment. Using an income tax refund to pay down high-interest debit (like credit card debt) can also provide an attractive return on investment.
Where To Invest
If you decide to save and invest your federal income tax refund, here are two investment options you might consider:
Traditional or Roth IRA —Traditional IRAs offer tax-deferred growth and an immediate tax break for individuals who qualify in the form of a deduction equal to the amount of their annual contribution. There is no tax deduction for contributions to Roth IRAs, but contributions grow tax-free, instead of just tax-deferred.
Keep in mind that eligibility for contributing to a Roth IRA phases out above certain adjusted gross income (AGI) limits. Also note that the maximum annual IRA contribution amount for traditional and Roth IRAs combined is $5,000 in 2012, or $6,000 if you are age 50 years or over.
401(k) —The annual contribution limit for 401(k) plans is higher than the limit for IRAs. If you participate in a 401(k) plan at work, you and your employer can contribute up to $17,000 combined in 2012, or $22,500 combined if you are age 50 or over. This might make a 401(k) a better option if you have already reached your annual IRA contribution limit.
Increase your Take-Home Pay
While receiving a tax refund might seem like a windfall, what it really represents is overpayment of taxes on your part throughout the year. If you receive a large refund, you have essentially granted the government a tax-free loan by having too much federal income tax taken out of each paycheck.
Instead, why not increase your take-home pay and keep the money for yourself? For example, if you receive the average federal income tax refund of $2,700 and get paid every other week, you could increase the size of each paycheck by about $104 by adjusting your federal withholding.
Some experts recommend adjusting withholding so that federal taxes are slightly overpaid at the end of the year. This way, you shouldn’t end up owing more money in taxes when you file your return—and should receive a small refund.
To learn more about these and other investment options for your tax refund, please contact David Lerner Associates at (877) 367-5960.