According to the Internal Revenue Service, the average tax refund received in 2005 was approximately $2,150. We know the giddiness that accompanies a refund check from Uncle Sam. We can't help but think of all the possibilities: a cruise, a set of golf clubs, a rolltop desk, a week in the mountains ... two grand can still buy a lot.
We don't want to discourage you from actually indulging in such luxuries, but may we suggest you put them off a bit -- say, 25 years?
In other words, instead of spending that refund now, invest that money in an individual retirement arrangement (IRA), where the money will grow and help create truly golden years.
Someone who deposits $2,150 in a Roth IRA, and earns 8% a year for 25 years, would add $14,724 to that nest egg.
It's not too late to fund an IRA for 2005. The deadline is April 17, even if you've already filed your taxes. However, if you choose a traditional IRA instead of a Roth, you'll have to re-file to get the deduction. Why bother re-filing? Because a contribution to a traditional IRA might be tax-deductible, which means an even bigger tax refund. Which is another reason to save for retirement -- Uncle Sam will pay you to do it, in the form of lower taxes. Contributions to your retirement plan at work and deductible traditional IRAs are tax-deductible, and the investments grow tax-deferred; withdrawals are taxed as ordinary income. Contributions to a Roth IRA aren't deductible, but the investments grow tax-free as long as you follow the rules.
And while it's nice to get that refund every year, you'd be better off not overpaying in taxes, and instead investing a little bit each month. It all comes down to the time value of money -- that is, the longer your money is invested, the more time it has time to grow. If you start in January, investing $179.17 in monthly chunks in the beginning of the year, you'd have $170,395 in 25 years (again, assuming 8% annual returns) -- approximately $10,000 more than if you instead wait until next year to get that tax refund and deposit $2,150 in your retirement account, and continue to do that over the same time horizon. So if you're getting a huge tax refund every year, adjust your tax withholdings downward and increase your retirement account contributions upward.
Don't know the difference between a traditional and a Roth IRA, or which is best for you? Looking for guidance on opening an IRA? Then consider a 30-day free trial of our Rule Your Retirement planning service. A quarter-century from now, when you're golfing in Scotland with your new clubs, you'll be happy you did.
Robert Brokamp contributes to an IRA and a 401(k) and knows to XYZ PDQ. He's also the editor of the Rule Your Retirement newsletter, which features special reports on asset allocation and supercharging your retirement.