The average tax refund was $2,729 for tax-year 2018, according to the IRS. If you're expecting some money back from the government this year, there are many ways to use it.
"Before deciding what to do with your tax refund, it is important to think about what your tax refund is and what it is not," says Vicki Bogan, associate professor at Cornell's Dyson School of Applied Economics and Management at the SC Johnson College of Business. A tax refund is not free money or a bonus. It is an amount that you have overpaid in taxes. If your employer withheld $10,000 from your paycheck during 2019 for taxes, and you find you owe the IRS just $7,000, you can expect a tax refund of $3,000 this year.
Here's how your tax refund can help you prepare for retirement:
-- Pay off debt.
-- Pad a health savings account.
-- Create an emergency savings stash.
-- Fund an IRA.
-- Evaluate your 401(k).
-- Invest in your well-being.
Since this sum comes once a year and may not fall into your regular budget, you might decide to use it to save for the future and build wealth for later years. Here are guidelines to help you decide how to put a tax refund toward retirement.
Pay Off Debt
This may not seem like a straight path toward funding your retirement, but if you get rid of debt, you'll end up saving money that you would otherwise spend in interest payments. "If your credit card balance is $1,000 and the APR on that card is 18%, you'll spend more than $2,000 in interest over the course of 12 months for that $1,000 debt," says Daniel Hill, president and CEO of Hill Wealth Strategies in Richmond, Virginia. By using your tax refund to pay off the debt, you could free up funds from your regular paycheck that could be put into a savings account.
Pad a Health Savings Account
A health savings account can be set up to help you pay for health care. The funds you put in can be deducted from your income when you pay taxes, and the money in the account can accumulate interest over time. When you take out the money and use it for medical expenses, the funds won't be taxed. "If you can, you should maximize your contributions to your HSA from your tax refund check," Hill says.
The contribution limit in 2020 is $3,550 for individuals and $7,100 for families with a high-deductible health plan. "Once you turn 65, your HSA can be used to make non-medical withdrawals for expenses incurred from long-term care and even for items such as hearing aids, corrective lenses and dental devices," Hill says.
Create an Emergency Savings Stash
If you don't have an account where cash can easily be taken out for an unexpected expense, consider setting one up. You'll be able to pay the bill when your car needs a new tire or your dog goes to the vet without taking on debt or dipping into other long-term savings accounts. "Once you have this fundamental financial strategy in place, you'll feel comfortable using next year's refund to invest," says Chad Tourin, a certified public accountant and agency managing associate at Coastal Wealth in Fort Lauderdale, Florida.
Fund an IRA
An individual retirement account can help you build funds for your golden years. Once you put money into an IRA, you can use it to buy investments, such as stocks or mutual funds. The two main types of IRAs are traditional IRAs and Roth IRAs.
With a traditional IRA, the money you put in can be deducted from your income at tax time. When you take out the funds, the money will be taxed. A Roth IRA doesn't let you deduct your contributions from your income, but the funds can be withdrawn tax-free.
If you think your current tax bracket is higher than it will be when you retire, it generally makes sense to use a traditional IRA. If your tax bracket may be higher in the future, then the Roth IRA might be a better option.
You can contribute up to $6,000 to a traditional IRA or Roth IRA in 2020 if you're age 49 or younger. For individuals who are 50 years old or older, the limit is $7,000.
If you're self-employed or own a small business, consider a simplified employee pension IRA. This type of IRA allows you to set aside more funds, with a contribution limit of 25% of net earnings up to $57,000 in 2020. If you have employees, you'll need to contribute the same percentage to their accounts as well.
Evaluate Your 401(k)
If your company offers a 401(k) plan, look to see if you are contributing as much as possible. These accounts are designed to help individuals save for retirement. Some companies will match what you give, up to a certain percentage or amount. "Make sure you've contributed to your employer-sponsored retirement plan up to the company match to maximize your employer benefits," says James Nichols, senior vice president of customer solutions at Voya Financial in Windsor, Connecticut.
Invest in Your Well-being
If you want to improve your health this year, consider using the extra dollars toward fitness or nutrition. "Active people tend to have fewer health problems and lower health care expenses as they age," Nichols says. "Spend your tax refund on a gym membership or a personal trainer or coach. Your body and your savings will benefit in the long run."
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