It's tax season once again. Generally, around three out of four Americans receive refunds from the IRS each year. The average tax refund in 2022 was close to $3,300.
If you have high-interest debt, the best way to use your tax refund is to pay it down. After that, it's wise to use that money to build an emergency fund big enough to cover at least three to six months of your living expenses.
But if you've checked off those boxes, consider investing the money you're about to get back from the IRS. There are plenty of options to choose from, but one especially stands out to me right now. Here's where to invest your tax refund to make an annualized return of 6.89%.
Image source: Getty Images.
A smart way to use your tax refund
The interest rate for Series I savings bonds (also known as I bonds) currently stands at 6.89%. These bonds are issued by the U.S. Treasury and earn interest on a monthly basis.
Individuals can buy up to $10,000 of these I bonds electronically through the TreasuryDirect website each year. However, if you receive a federal tax refund, your annual limit is higher, because you may also buy up to $5,000 worth of paper I bonds using tax refunds.
These bonds mature in 30 years. You don't have to hold them for that long, though. You can cash in I bonds at any time after 12 months. The only drawback is that if you don't hang onto them for at least five years, you'll forfeit the last three months of interest.
I bonds pay much higher interest rates than you'll get from most certificates of deposit (CDs) or money market accounts. Their rates are also well above the current levels for 12-month and 10-year U.S. Treasury bonds.
Some variability
If you buy I bonds this month, that annualized rate of 6.89% will be locked in through Sept. 1. The interest rate will then be updated based on the inflation rate.
The worst-case scenario (at least with respect to your returns from I bonds) is that inflation completely goes away in a few months. If that happened, your I bond interest rate would fall to 0.4% (the fixed rate) between Sept. 1, 2023, and March 1, 2024. However, you would still make the higher annualized rate of 6.89% before then.
Of course, this scenario is highly unlikely. Inflation does appear to be moderating somewhat, but it still stood at 6% over the 12-month period that ended in February.
It's also possible that the interest rate for I bonds could increase in September if inflation rises. With the Federal Reserve committed to fighting inflation with interest rate increases, though, you probably shouldn't count on I bond rates moving higher.
The I's have it
Keep in mind that Uncle Sam giveth and Uncle Sam taketh away. You will have to pay federal income taxes on any interest earned from I bonds, just as you would with any other U.S. Treasury bonds. The good news, though, is that this interest isn't subject to state or local income taxes. But whether or not you report the earnings each year or wait until you sell the bonds is up to you.
It's possible that you could make even better returns by investing your tax refund money in other ways. However, if you're looking for a great inflation-proof investment, I bonds rank at the top of the list.
