About 80% of all taxpayers will get a refund in 2016. And the IRS expects the average refund to be a whopping $3,120. If you are like most people, you're already planning all of the things you can do with your refund. But it pays to put some thought into your decision. And if you are thinking about putting your tax refund toward your retirements savings, here is would you should know.
According to recent surveys, most Americans planned to use their refund to pay down debt (approximately 40%) or save and/or invest (also approximately 40%).
Unfortunately, sometimes there is a gap between your intentions, and what you actually do with your tax refund.
While I am not going to discourage you from using a small part of your refund to splurge, I do want to encourage you to pay down debts and add to your savings.
And it will probably be a lot easier to invest your savings if you understand how you can put your tax refund to work for you.*
Three Ways to Invest Your Refund For Retirement
Here are 3 ways to take all or part of your tax refund and use it to contribute towards your retirement savings.
Option 1: Fund Your IRA
Did you can fund your own individual retirement account (IRA) even if you have a 401(k) through your job? In many cases, you can!
For 2015 and 2016, you can contribute up to $5,500 (or $6,500 if you're 50 or older). This limit applies to traditional IRAs and Roth IRAs, but Roth IRA contributions may be limited depending on your income and filing status. If you're self-employed or a small business owner, you can fund a SEP IRA, a type of traditional IRA.
The IRS allows you to make 2015 IRA contributions until April 18, 2016. This means you can claim contributions you have not yet made on your tax return, as long as you make the contribution before the deadline. If you file early enough, you can claim a 2015 IRA contribution on your 2015 taxes, wait for your refund, then put your refund directly into your retirement account!
You have the option of directing all or part of your refund directly into an IRA. If you go this route, you will need to set up the account before you request a direct deposit, and inform the IRA trustee that the IRS will transfer money into the account. You will also need to let the IRA trustee know which tax year you want the deposit applied toward.
The beauty of this option? Not only will you be funding your own retirement, your contributions may be tax-deductible to lower your tax bill next year.
Traditional IRA vs Roth IRA
There are two main types of IRAs: the Roth IRA and the traditional IRA. The type of IRA you choose will affect your savings and taxes. Both IRAs offer tax breaks, but the type of IRA you choose impacts when you get to enjoy the tax advantages.
Contributions to a traditional IRA are tax deductible for the year in which you make the contribution, and withdrawals in your retirement are taxed at a regular income tax rate.
With a Roth IRA, you get no tax breaks for contributions, but the earnings and withdrawals are usually tax-free.
To make it simpler: a Roth IRA lets you avoid taxes when you take out your money while a traditional IRA lets you avoid taxes when you put the money in.
Option 2: Max Out 401(k) Contributions
Another option is using your refund to increase your 401(k) contributions. To do this, put your refund into an interest-bearing savings account, then talk to your human resources department to adjust the amount of your paycheck that goes into your 401(k) by the same amount as your refund. You'll earn interest on the amount in the savings account, and you can withdraw enough each month to compensate for the bigger bite coming out of your paycheck.
For 2015 and 2016, the IRS has a 401(k) contribution limit of $18,000 (or $24,000 for people 50 and older). The annual contribution limit from all sources (including your employer) is $53,000. Your refund can go a long way toward hitting that limit -- especially if your employer matches contributions.
Option 3: Invest Your Refund
Already maxing out your 401k and IRA accounts? Why settle for the extremely low interest rate a standard bank savings account will give you? You can deposit all or a portion of your refund directly into a brokerage account, mutual fund account, or cash management account.
Investing your money is a great option after you have maxed out contributions to tax-advantaged plans like 401(k)s and IRAs.
If you're new to investing, an online brokerage is an affordable and easy way to get started. Online brokers usually offer low fees with the ability to invest your money in stocks, bonds, mutual funds, futures, and more.
The younger you are, the more risk you can safely take with your retirement account. Some people find it easiest to begin with mutual funds, which are collections of bonds and stocks, as you can invest your money without much experience or time.