Nearly 55 million Americans have already filed their 2022 taxes, and over 42 million have received refunds so far. The average refund is trailing a little behind last year's, but it's still a decent payday at $3,028.
There are a lot of great ways to use that money. You could beef up your emergency fund, pay down debt, or even spend it on something you've had your eye on. But you might also want to consider investing it in a Roth IRA. Here's a look at the pros and cons of doing so.
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The pros of investing your tax refund in a Roth IRA
Putting money in a Roth IRA will help you better prepare for your retirement. Your refund might only cover a month or two of expenses right now, but it could go a lot further after it's been invested for a while.
If you deposited that average $3,028 refund in a Roth IRA right now and you earned a 10% average annual rate of return, it would be worth about $7,854 in 10 years; it would reach around $20,371 after 20 years. And that's not even the best part.
Roth IRAs allow for tax-free withdrawals in retirement (provided you're at least 59 1/2 years old), which means the government generally ignores any money you take out of these accounts when calculating your tax bill for the year. This could make a Roth IRA one of your greatest financial assets in retirement.
All the money in there belongs to you, and you can leave it in the account as long as you want without worrying about required minimum distributions (RMDs) -- mandatory annual withdrawals the government makes seniors take from most other retirement accounts.
The cons of a Roth IRA
Roth IRAs are more flexible in some ways than other retirement accounts because they enable you to withdraw your contributions tax-free at any age. But you can still pay taxes and penalties for withdrawing your earnings if you're younger than 59 1/2 and before you have had your account for at least five years. So it's generally not a good idea if you lack an emergency fund or plan to spend your cash within the next few years.
You also won't get any sort of tax break today, like you would if you put the money in a traditional IRA or a 401(k). The price for the Roth IRA's tax-free withdrawals is owing taxes on your contributions in the year you make them.
It's probably not a big issue if you believe your income will be about the same or higher in retirement. But if you're in a high tax bracket now and you anticipate your income dropping significantly in retirement, a Roth IRA might not be a great fit for you.
Make sure you're eligible to contribute to a Roth IRA first
Roth IRAs have income limits, which restrict how much high earners can contribute to these accounts. You should review these if you plan to put your tax refund in a Roth IRA so you don't create more problems with the IRS.
Most people are able to contribute up to the annual maximum: $6,500 for adults under 50 in 2023 and $7,500 for adults 50 and older. Some high earners will still be able to place money into a Roth IRA, but not up to these limits.
If you earn more than $153,000 as a single adult or $228,000 as a married couple filing jointly, you won't be able to put money directly into a Roth IRA this year. But you can use a backdoor Roth IRA to achieve the same effect -- you put money into a traditional IRA and do a Roth IRA conversion in the same year. It requires a few extra steps, but it can help you get the Roth savings you want.
And if you don't think a Roth account is right for you, you can always stick with your traditional IRA funds. You will get your tax break now, rather than in retirement, but you'll still be able to grow your savings for your future.
