By Lori Schock, Director of the SEC’s Office of Investor Education and Advocacy
It’s tax time. If you’re fortunate enough to be getting a tax refund this year there are countless ways you can spend the money−going on a vacation, buying a car, or upgrading your computer. While all of these are certainly worthwhile expenses, consider “spending” some or all of that tax refund on investing for your financial future. Planning for your financial future is time and money well spent.
First Things First
Before you invest your tax return or even begin investing at all, there are two things to consider. First, no investment strategy consistently pays off as well as, or with less risk than, eliminating high-interest debt. Most credit cards charge high interest rates−as much as 18 percent or more−if you don’t pay off your balance in full each month. No investment will give you guaranteed returns to outweigh the high interest rate you generally pay with a credit card or other high-interest debt.
Second, make sure you have an emergency fund. If you are able, saving three to six months of living expenses in an emergency fund will provide you with peace of mind when life throws unexpected financial emergencies at you. Whether it’s a car accident, medical issue, or other unexpected repairs or expenses, having an emergency fund can help you weather these financial situations and minimize the impact they may have on your future financial and investing plans.
Now, let’s move on to saving and investing!
The Power of Compounding
The earlier you start saving and investing, the less money you’ll need to invest to reach your financial goals. Through the power of compounding, you can earn interest on the money you save and on the interest that money earns. You can watch your money grow over time even if you only put a small amount of that tax refund money into savings right now.
For example, if at 25 years old you start investing $100 a month for the next 40 years, you would have invested $48,000. Because of the power of compounding, assuming a seven percent annual return, that $48,000 would grow to $239,562. Without lifting a finger that winds up being more than five times more than you initially contributed!
As an added bonus, the power of compounding can also help you keep up with inflation.
Use the compound interest calculator on Investor.gov to help determine how much your money can grow using the power of compounding.
Tax-Advantaged Retirement Accounts
With taxes on our minds, it’s a good time to look into the IRS’s tax incentives when saving for your retirement. For example, if you’re considering investing in an individual retirement account (IRA), both options−Traditional or Roth−have different tax implications. A Traditional IRA allows your money to grow tax-free until you start taking it out for retirement. When you withdraw the funds, the money will be taxed. For a Roth IRA, you are taxed at the time you make your contributions and your money will grow tax-free without any future taxation. You should consider your tax rates now and what they might be in the future to decide whether you want to pay taxes now or later. And for the best advice, consult a tax professional.
While you’re considering investing your tax return money in a tax-advantaged account, you may want to consider investing in a target date fund, which provides a long-term investment strategy. A target date fund is a mutual fund that includes a mix of stocks, bonds, and other investments that automatically adjusts your mix of investments over time. In the beginning, typically your investment portfolio is more aggressive, perhaps higher risk, and as you get closer to retirement it adjusts to a more conservative, less risky mix of investments.
This kind of long-term investment strategy allows you to basically set it and forget it, allowing you to have some investing peace of mind.
If you are not maxing out your contributions to your employer’s retirement accounts, such as a 401(k), 403(b) or 457(b) plan, and your tax refund gives you enough extra financial cushion, you may want to consider increasing the amount of money you deposit into these accounts. Especially consider this option if your employer contributes to these accounts and you don’t currently take full advantage of these matching funds. Say your employer contributes 50 cents for every dollar you save up to five percent of your pay. If you make $50,000 a year, and contribute at least $2,500 to these accounts, your employer will add an extra $1,250 to that amount. That’s an immediate 50 percent return. Take advantage of the “free money” as no other investment will give you that kind of guaranteed return.
Instant v. Long-Term Gratification
As you can see, there are a number of ways to spend your tax refund money. Rather than spending your tax refund on some instant gratification, consider taking that money and investing it to meet your long-term financial goals. Every little bit of extra saving and investing helps. Believe me, you’ll feel a lot more gratification knowing you’re making an investment in your financial future.
Note: Director’s Take articles are written in a short, non-legalese format intended to provide you with tips and information on timely investment topics that are important to you.