Use Your Tax Refund to Live Your Best Life
Note: This article has been updated reflect the most recent IRS contribution and income limits for 2020.
Disclaimer: this post contains affiliate links to products I personally use or strongly believe in.
Get a tax refund this year? YEAHHH! We know you worked hard, and while you may be tempted to blow it all on an a big vacation, here are three options you might consider to make your money work for you, for a change.
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Build up your emergency savings
While it may be tough not to throw your refund at the nearest vacation destination you can find, remember that your emergency savings are key to keeping the rest of your financial goals on track. Beworth Finance recommends keeping 4-6 months’ worth of your total spending in a high-yield savings account (like Ally Bank or Synchrony). At the very least, your emergency fund should cover your fixed and necessary expenses like rent, groceries and transportation. Ideally however, it would cover your entire monthly budget, extending past the necessities to include your monthly savings and investment contributions as well. The reason for this is that even a 2-3 month freeze on investing now, can cost you long-term gains in appreciation and dividends over time. Having a sufficient emergency fund prevents your long-term goals from falling off the tracks.
Having 4-6 months’ worth of savings in an emergency fund may seem crazy now, but keep in mind the amount of money and interest you would owe later if you were forced to put a large, unexpected expense on your credit card. Can’t wrap your head around 4-6 months' worth of savings just yet? Start with a goal of $1,000 and work your way up. Any amount you have on hand in the event of an emergency, will save you from using credit later.
Bump up your retirement fund
Now is a great time to use your tax refund to set up or contribute to an individual retirement account (IRA). An IRA is a type of retirement account, separate from the 401(k), 403(b) or 457 your employer may offer. Even if you only contribute $2,000 once per year, with a historical rate of 7%, that would be $137,353 in 25 years — that’s almost $86,000 in free money! The deadline for contributing to a traditional or Roth IRA for the 2019 tax year is April 15, 2020, with a maximum contribution limit of $6,000 for the year. For 2020, the limit is also $6,000, with a deadline of April 15, 2021. So max out 2019, then move to 2020, to get the biggest bang for your buck.
Already file your taxes for 2019? You can still contribute to an IRA after filing your taxes, hassle free, because it’s an after-tax investment. You can also contribute to a traditional IRA also, but it will require filing an amendment to your tax return.
There are different tax benefits to choosing between a traditional or Roth IRA, but we recommend a Roth IRA if you make under $137,000 per year, because it’s sort of like an awesome savings account (although there is risk involved). In a traditional IRA, you face a 10% penalty if you need to access your money before you’re 59.5 years old. In a Roth IRA, you can withdraw your contributions (but not earnings) penalty free, anytime, making it a safer option in case you the need the cash later.
Investing your tax refund is one money move.
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Need help in setting up an IRA? We like NerdWallet’s review of providers here.
A quick note: Already contribute to a 401(k), but have no idea what’s in it or if it can be doing better? Check out Blooom for a free 401(k) analysis to see if your retirement fund could be working harder.
One more thing: If you do make more than $139,000 per year (lucky you!), you’re not eligible to contribute to a Roth IRA directly, but you can do a backdoor Roth IRA conversion, which is completely legal, just get’s a little tricky. If you’re curious you can learn more here.
Be the next Warren Buffet (the billionaire investing pro)
Separate from your retirement account(s), your tax refund is a great opportunity to invest in the stock market. A lot of young people tend to be scared of the stock market, and why wouldn’t they — many of us were just starting our careers during the worst recession since 1931. But you know a great way to get over that fear? Use the tax refund you didn’t have a week ago.
That, and if you have a 401(k), then you’re ALREADY investing. People always seem to forget that...
If you have the risk appetite, consider investing your tax refund directly in an index fund or through a brokerage account. Think of it this way — it isn’t money you had prior to your tax refund, and as long as you have sufficient emergency savings in the bank and no debt, you might as well see if you can make your refund grow. You may have heard about people freaking out when the market dipped at the end of 2019, but rest assured, historically, the market has outperformed every other savings vehicle out there in the long term. Plan to keep your money in for at least 5 years, if not much, much longer.
Don’t know where to start? Luckily, finance technology platforms and tech-friendly advisors have become widely available over the past few years. Consider using a “robo-advising” service if you want all the hard work done for you, or if you’re picky, a regular online brokerage account.
If you’re in that first group, or just getting comfortable with the idea, check out a “rob-advising” service like Wealthfront or Betterment, which based on a short quiz will asses your risk tolerance, and have you link a bank account to start investing right away. You can start for as low as $500 and you’ll have access to an online dashboard where you can track all of your investments over time. Even more importantly for the newbie investor, these platforms will ensure your portfolio is property diversified, which lowers your risk (read: there’s a higher chance you’ll make more money). Want the option to speak to a professional too? Many services also offer 1-1 advising, or hybrid approach, so you can talk to a financial advisor when your laptop isn’t cutting it.
Know exactly what stocks you want to invest in? Or maybe you just don’t trust anyone else with your money? We get it. Online brokerage accounts like E*TRADE provide as little or as much flexibility as you’d like. Just link your bank account, decide which options you want to invest in and how much — you can even buy stock in Netflix if you want. Now that’s our type of Netflix and chill :)
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