As of the end of January, the average tax refund processed by the IRS for this year's tax season was $3,539. That's a substantial chunk of change in and of itself, but it could be worth even more. If you're one of the people receiving a refund around that level, you may be able to turn that money into $10,000 or more for your retirement by the end of this year, with no other impact to your lifestyle.
To make it work, you need:
- Your refund check
- IRS Form W-4 or your employer's substitute
- The ability to contribute more to your traditional 401(k) at work (2015 limits: $18,000 for those under age 50, or $24,000 if age 50 or up)
- An employer match to that 401(k)
- The ability to contribute more to your IRA (2015 limits: $5,500 for those under age 50, or $6,500 if age 50 or up)
Your step-by-step how-to guide
Step 1: Contribute your refund check to your Individual Retirement Account (IRA). If you received a $3,500 refund check, that fits nicely within the IRA contribution limits for the year. That's a nice chunk of change for your retirement, based on money you didn't need to live on over the past year.
Step 2: Increase your contributions to your traditional 401(k) based on the money you over-withheld. The basic math is: Refund / (1-tax bracket). If you're in the 25% tax bracket, that becomes $3,500 / (1-0.25) = $4,666. In other words, your paycheck would have been the same if you had gotten your tax withholdings correct and instead contributed $4,666 more to your traditional 401(k).
Step 3: Adjust your withholdings at work to come closer to break-even. Using IRS Form W-4 or your employer's substitute, adjust the taxes being withheld from your paycheck so you come close to break-even when your file next year. This adjustment will make it so that you don't really feel the loss in income from the increased 401(k) contributions. You won't get it perfect, but as long as you wind up within the IRS's safe harbor guidelines, you won't be penalized if you do owe a little when you file next year.
The basic safe harbor guidelines are:
- If you owe less than $1,000 when it's time to file.
- If you've paid at least 90% of what you owe for the year through withholdings or timely estimated taxes.
- If you've paid at least 100% of what you owed for the previous year through withholdings or timely estimated taxes. (That percentage becomes 110% of last year's taxes if your income last year was at least $150,000 -- or was at least $75,000 and you file as married filing separately.)
Step 4: Thank your employer for its match. Matches differ from company to company, but a fairly typical offering is a 50% match of your contribution amount, up to some limit of your salary. If you get a 50% match on your contribution, that adds $2,333 to your retirement for the year.
Step 5: Count your money. A $3,500 refund check in your IRA, plus your $4,666 contribution increase to your 401(k), plus your employer's match of $2,333 gives you $10,499 in your retirement for the year. All of that is yours, enabled by your willingness to invest this year's refund check in your retirement and set yourself up so that next year's prospective refund gets contributed to your retirement in advance.
How often can you save $10,000 with no impact to your lifestyle?
Perhaps best of all, that $10,000 added to your retirement took place with absolutely no impact on your day-to-day lifestyle. That $3,500 tax refund check in your IRA? That's money you lived without for all of last year. The $4,666 in new contributions to your 401(k)? That's covered by changing your withholdings so you don't get the same refund next year. The $2,333 employer match? That's extra money your boss is handing you just for making your contribution.
That $3,500 check might be fun to hold, but as the lynchpin for adding $10,000 to your retirement this year, it's an extra-special treat. So take that money, put it to good use for your future, and enjoy knowing that you added a substantial amount to your future financial stability without any new sacrifices today.