When my husband and I filed our 2016 taxes, we realized we owed almost $20,000 in federal taxes instead of getting a tax refund. I was shocked. I thought I was paying the right amount all year only to learn I was underpaying while my husband was paying just enough. This expensive lesson taught us to do better tax planning, including end-of-the-year tax planning, with a certified public accountant (CPA).
Because of my CPA’s advice, I increased my tax payments per pay period. However, out of fear of underpaying again, I was too aggressive with my payments. We got a tax refund for 2017 and getting a tax refund is not a good thing. This year, I have to adjust my payments a bit more, but since we have this cash coming back to us, my husband and I have created a plan for the money. I plan to follow my CPA’s advice exactly in 2018. I have already decreased my additional tax payments to eliminate the possibility of a 2019 refund, which is a free loan I give to the government.
Each year, almost 80% of Americans qualify for a tax refund. Instead of spending that money on new clothes, popping bottles, or other stuff you don’t need, try investing it. Extra windfalls of money are great for investing since your monthly budget won’t need it.
1. Invest in an Emergency Fund
If you overpaid your taxes last year but don’t have at least $500 in the bank for an emergency, you have a problem. But don’t panic. Your tax refund is your solution. As soon as you get your tax refund, deposit the money into a savings account.
Look for a bank that offers you a high-interest rate (say 1% or more) and make sure your money can be easily accessed if you need it for an unexpected expense. Consider online banks for the best interest rates. They tend to have lower overhead costs since they do not have physical locations. As a result, they pass some of these cost savings to their customers in the form of higher interest rates for your money. Credit unions are also a good place to search for higher rates, but those may require membership to get their rates. Capital One 360 is one bank with great service and some of the highest interest rates on money market accounts.
Before you have an emergency, you and your family should write down what you consider an emergency. Medical expenses, job loss, or urgent car and home repairs should make the list. However, buying the latest Gucci bag or going on a vacation you cannot afford are not good uses of your emergency fund. Strive to save the equivalent of three to six months of your monthly expenses in this account. After you have saved six months of your expenses in a savings account, look for other places to invest extra income. Consider some of the investments below where you can make more than 1% on your money.
2. Make a Lump Sum Retirement Contribution
If you have funds set aside for an emergency, the next item on your list should be saving for retirement. Banks do not offer loans for retirement, so it’s up to you to save and invest for this phase of life.
If your job offers to match any of the money you invest in an employee retirement plan, invest enough to qualify for the matching funds and take the free money. If you have additional income, invest in an Individual Retirement Account (IRA) to save even more for retirement.
IRAs come in two forms: traditional and Roth.
A traditional IRA is a tax-deferred retirement savings account. This means you pay taxes on your money only when you make withdrawals in retirement. While you are working and contributing to your traditional IRA, the IRS allows you to claim tax deductions for your contributions in the year they are made. Traditional IRAs do not have income limits, so you can invest in them regardless of your annual income.
With a Roth IRA there are no tax deductions when you make contributions, but when you withdraw the money in retirement your money is not taxed. While you are working and contributing to your Roth IRA, your investment grows tax-free. Since no one can predict the tax rates in retirement it’s a huge benefit to have investments, like a Roth IRA, that allows you to withdraw money and not pay taxes on that income. Unfortunately, Roth IRAs have income limits. Many people do not qualify for the Roth IRA for very long if they have high salaries or a high combined household income. So invest in a Roth IRA as early and as soon as you can. Anyone with a job (including teenagers) can invest in a Roth IRA.
The IRS sets the same contribution limits on the traditional and Roth IRAs. For 2018, if you are under 50 years old you can contribute up to $5,500 per year and anyone over 50 can invest up to $6,500.
3. Build a College Fund for Your Children (or Yourself)
With student loans crippling college graduates, it’s important for parents to consider contributing to their children’s education.
A common way to save for college and give yourself a tax break is to invest in a 529 plan. A 529 is a college savings plan you invest in today to save for future college expenses. Most 529s are opened by parents to pay for their children’s education, but you can also start one for yourself to pay for your own college education or advanced degree. If you are willing to invest the effort, a Roth IRA might be a better option for your child.
4. Invest in Securities With a Robo-Advisor
Building wealth by investing in the stock market is possible and not limited to just the rich. Most families who save consistently, and over time, can get millions simply by having discipline and a diverse portfolio.
However, rather than investing in individual stocks, research has shown that investing in diverse equities can be very lucrative. This means you should invest in funds that include thousands of companies that are domestic and foreign, large and small.
Furthermore, when these funds are managed by robo-advisors you can save money on fees. Robo advisors give you a well-diversified portfolio, catered to your risk tolerance, and add in benefits like free trades, rebalancing and tax loss harvesting. Historically, this type of wealth management service was reserved for only the wealthiest of individuals. But now anyone, with any amount of money, can get all of the wealth generating benefits for a fraction of the cost.
Wealthfront is our robo-advisor of choice. Learn more about how they can manage your money for super low fees.
5. Pay Down Debt
When you borrow money, at some point you have to pay that money back. Anyone that keeps a balance on their credit cards is paying more for their purchases thanks to credit card interest. It is important to know how much meals and retail purchases on a credit card are really costing you. Check out this example.
The Real Cost of Debt
|Original Amount Borrowed||$4,500||$4,500|
|Time to Pay Off Debt||21 years, 10 months||10 years, 9 months|
|Total Cost of Debt||$10,673||$7,074|
In this example, paying an extra $67.50 a month would get rid of the debt 11 years sooner and save you over $3,000. Putting extra payments toward debt has a very real benefit to your ability to build wealth.
So if you are getting a tax refund, use it to pay off debt. This is a great way to invest in yourself. Once you pay off your credit cards don’t use them unless you can pay for the purchase when the bill is due. Learn more about good debt vs. bad debt too.
6. Buy Stocks or ETFs
The benefit of a tax refund is the instant access to a lump sum of cash. This cash could be invested in specific company stocks or exchange-traded funds (ETFs). Exchange-traded funds were invented in 1993 and are the more evolved version of mutual funds. They provide easy ways to invest in thousands of companies at the same time. Best of all, the fees are sometimes lower than the cost of mutual funds. Like with most stocks, ETFs have the best results over the long term and you should consider them for a one year or longer investment, but you can sell at any time. Now, there are ways to avoid paying trading fees with newer online brokerages for millennials. You can even use your refund to buy a country with ETFs.
If you qualify for a tax refund make sure to invest it in something that helps build your family wealth or meets your financial goals. Also, remember to make adjustments to your tax payments during the year so more of your money comes to you each paycheck and you minimize your chances of a refund in the future. The goal should always be to break even with Uncle Sam.
How do you plan to use your tax refund? Leave a comment and let us know if you plan to take action on any of these ideas.
Acquania Escarne is the creator of The Purpose of Money, a community of women building generational wealth for their families one dollar at a time. As an entrepreneur, real estate investor, and licensed insurance agent, Acquania has always been passionate about financial literacy. On her website, Acquania blogs about ways to help you improve your money habits, create wealth, and invest in real estate. Follow Acquania on social media for daily tips.
Great list. There are limits on the tax deductibility of Traditional IRA contributions if you also have access to an employer sponsored account like a 401k or 403b. I think the phase out starts at $63K for single people and cuts off completely at $72K. Just something to keep in mind if you’re trying to arbitrage the tax situation.
Damien Peters says
This is very true. The gov’t is not trying to help your retirement our once your salary starts getting up there.
Besides HSAs (thanks again for that article and I’m still waiting on your next one), there is always a normal taxable account and I’ve been meaning to look more into a SEP IRA. I had a friend who said he qualified because he drove Uber for awhile and rents out his apartment for Airbnb, even though he works. Their limits are much much higher. On my ever growing todo list of tactics I need to research and share.
Your tax return is not a windfall. You didn’t win the lottery. As you say at the top of the piece, you miscalculated your withholdings and the gov’t got free use of your money through out the year that you could have invested. The IRS has a calculator to help you figure it out. Worth running the numbers, especially with the tax law changes for 2018. I recalculate mine every quarter and include deposits to my emergency fund and investment accounts in my monthly budget throughout the year.
Damien Peters says
This is a well written article, filled with helpful recommendations. I’m going to check out the roboadviser your recommended.
I’m a 27 year old single mother of three, I am so happy to have found this article . I want to create generational wealth I just didn’t know how to get started . I have an idea now and I’m so grateful that you posted this article now I can use my money wisely and educate myself for years to come . Thank you .
Acquania Escarne says
This is great! Thanks for your comment.