As the year comes to an end, some of you may find yourselves with a holiday bonus. Or maybe you didn't spend quite as much on gifts as you budgeted for, and now have some extra cash sitting around. Whatever the reason, if you happen to have $1,000 or so in the bank and want to put it to work, here are three ways you could use it and possibly boost your tax refund in the process.
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1. Boost your retirement savings
Perhaps the best tax breaks of all come from retirement savings. Not only do you get a nice tax deduction (either now or down the road), but you'll also set yourself up for financial freedom later in life. If you have some extra cash to invest, putting it into a traditional or Roth IRA is a great choice.
With a traditional IRA, you may be able to deduct your contributions on your tax return this year. This depends on how much you earn, and whether or not you have access to an employer's retirement plan. A Roth IRA, on the other hand, doesn't allow for a current-year deduction, but your qualified withdrawals will be 100% tax free in retirement. Other benefits of a Roth IRA include their lack of a required minimum distribution, and the ability to withdraw your contributions whenever you'd like.
The ability to contribute directly to a Roth IRA is subject to income limitations. You can find a discussion of the restrictions for both types of IRAs here.
For 2016, the maximum annual contribution to both types of IRA is $5,500, with an additional $1,000 allowed if you're 50 or older. This is a cumulative limit, so if you have more than one IRA, your total contributions cannot exceed that sum. Both account types allow your money to grow on a tax-deferred basis, meaning that you won't have to worry about capital gains or dividend taxes each year.
It's also worth noting that you can make IRA contributions for 2016 until the tax deadline on April 18, 2017, so you have plenty of time to take advantage of this one.
2. 'Tis the season for giving
It's a well-known fact that charitable donations are tax deductible. Unlike the deductions for retirement savings I discussed earlier, charitable contributions must be made by midnight on New Year's Eve to qualify for your 2016 tax return. So, your $1,000 could be put to great use for a worthy cause, and reduce your tax bill at the same time.
One thing about charitable deductions that isn't well understood is the documentation requirement, which varies depending on whether you donate cash or property, and how much you give. For cash donations of less than $250, a cancelled check or simple receipt from the organization is sufficient, but if you donate, say, $1,000 to a charitable organization, be sure you get written confirmation from it.
For a more complete discussion of the rules of charitable giving, check out this other article.
3. Save for education
Finally, one of the best uses for extra money (especially if you have kids) is to start saving for their education. It's never too early to do this, and in fact, earlier is better. My daughter is 1 year old, and I've been saving aggressively in a 529 Savings Plan since she was born.
What's the rush? In a nutshell, the two most popular types of college saving plans -- the 529 Savings Plan and the Coverdell ESA -- allow you to invest your money on a tax-deferred basis for your child or another relative's education. Because of the power of compound returns, the money you contribute early in your child's life has the highest potential to grow.
For example, let's say that the investments you choose grow at a 7% annualized rate, on average. If you contribute $1,000 to your child's account when they're 10, it will grow to $1,720 by the time they turn 18. On the other hand, if you contributed that same $1,000 when they were born, the money will have grown to $3,380 by the time they're ready to use it.
If your children are a little older, don't worry -- it's still a good idea to contribute. My point is just that the best time to do it is right now, as your investment dollars will never have more long-term growth power than they do today.
As far as tax benefits go, contributions to these education savings accounts don't qualify for a federal tax deduction. Instead, they are treated like Roth IRA contributions (see my earlier discussion). The investments grow and compound in a tax-deferred account, and all qualified withdrawals are completely tax free. Your state may allow you to deduct 529 contributions on your state return. Most, but not all, states that offer that restrict it to contributions to their specific state plans, so check out the plan(s) offered in your state. In my state (South Carolina), a $1,000 contribution translates into $70 in tax savings for me, so this can be a nice tax benefit now as well as years down the road.
