If you're among the millions of Americans who received a tax refund this year, it might be tempting to go out and splurge on clothes, a new TV, or a down payment on a new car. However, if you can resist these temptations, it could go a long way toward your long-term financial health. Here is a quick guide to why you should consider putting your tax refund to work for you and how to get started.
Your refund could be worth a lot more than you think
Before you go on a shopping spree, consider the long-term value that you lose by spending your tax refund. Let's take a look at an example and what it could mean when you hit retirement age.
If you receive a $3,000 tax refund, it could probably buy a lot of nice stuff right now. Or, you could invest it and earn compounded returns on your money. The S&P 500 has produced an average total return of nearly 10% annually over the past 50 years. So, if you just put your tax refund money in an index fund and left it there, look at how it could grow over the next 30 years.
If your refund is higher than $3,000 or you have more than 30 years until you plan to retire, the effect will be even more dramatic. If you're 25 and plan to retire at 65, that $3,000 could be worth almost $136,000 by then.
Speaking of taxes, use them to your advantage
The second thing you need to do is take advantage of your tax benefits when investing for retirement. For most people, the best way to do this is to invest through a Roth IRA so long as your income qualifies you. Currently, single taxpayers earning less than $129,000 per year and married couples filing jointly who earn less than $191,000 together can contribute to a Roth IRA.
A Roth IRA allows your money to grow tax-free so long as it's in your account. You'll also pay no income tax or capital-gains tax on withdrawals made after retirement age. Roth accounts are also a great choice because they come with a safety net: If the sudden need for cash arises, you can withdraw your original contributions (but not any gains) penalty-free, unlike in a traditional IRA or 401(k).
The best move you can make for your retirement is to max out your IRA contribution each year. The current annual limit is $5,500 (or $6,500 if you're age 50 or older), so if your tax refund doesn't cover the full amount, consider making up the difference throughout the year. You'll have until next year's tax deadline (April 15, 2015) to make a contribution that's counted in the 2014 tax year.
Using the above-mentioned average S&P return, if you were to max out a Roth IRA every year for 30 years, your account would grow to more than $1,000,000. And remember, you'll be able to withdraw that money tax-free once you retire. When you add that to Social Security and any 401(k) or similar plan you have at work, you can make a worry-free retirement for yourself with a relatively small investment now.
Position yourself for the future
If there is a legitimate expense you need to take care of, like high-interest credit card debt or day care for your children, by all means use your tax refund to pay it off. Just be sure to think about using your money in your best interests, which more often than not means saving it.
As a final thought, take another look at the above chart. Figure out how many years away from retirement you are. Now consider what a nest egg you could build up, using nothing but your annual tax refund, between now and then. It may be worth resisting the temptation to treat yourself now!
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