Seeing your tax refund hit your bank account: That moment when you feel like you have a little extra money to burn thanks to Uncle Sam.
Even though it’s tempting to spend your refund check, treating yourself to a vacation or a shopping spree — or even something more practical like paying down debt — there’s only one option that will actually make you more money: Investing it.
"When you invest, you have the opportunity to let your money make money for you,” says Sharon Allen, CEO and co-founder of Sterling Wealth Management based in Champaign, Ill. "And the earlier you do that, the more quickly it builds on itself and it's like a snowball rolling downhill.”
Investing your tax refund rather than spending or saving it affords you the benefit of compound interest, which means you’re earning interest on the interest of your original sum of money and creating that snowball effect that will benefit you in the long run.
So far this year, the average tax refund has been about $2,700, according to the IRS, with 47,700,000 returns processed so far (at the same time last year the average refund was about $2,900 with 49,992,000 returns processed). While these early reports from the IRS are only indicative of a certain percentage of U.S. taxpayers — we won’t know what the true average tax refund for the 2018 tax season is until after April 15th, when the majority of Americans have filed —they still offer a roadmap for how much the average tax payer can benefit financially from putting his or her refund to work in the market.
Assuming a conservative annual investment rate of 6%, if you invest a tax refund of $3,000 now, you would have $9,620 in 20 years -- even if you never add another dollar to the account. (At a 10%, the annual average total return for the Standard & Poor's 500, you would have $22,000. See how valuable compound interest is?)
If you invest a $3,000 tax refund every year for the next 20 years, you will wind up with a whopping $126,600.
To be sure, paying down debt is also a key part of building your wealth over time, so if you feel more comfortable putting half of your refund towards debt and half of it in the market, you'll still come out on top. After an initial investment of $1,500 this year with yearly deposits of just $200, you would end up with $12,600 in 20 years.
Tax payers who are very risk averse and concerned about a possible recession in the next few years have other options besides the stock market, thanks to today’s high interest rates. While you won't earn as much, on average, as you would long-term in the stock market, you can still benefit from putting your tax refund in a high-yield savings account or CD, or investing in bonds instead of equities, which lowers your exposure to market volatility.
Another way to pay yourself dividends is to adjust your W-4 withholdings, Allen says. If you are getting a big tax refund, you have in effect paid the government more than you owe. Instead of getting that money back in the form of a refund at tax time, you can decrease the amount of taxes withheld from each of your paychecks so that you don't receive such a big lump sum just once a year.
"Use that regular cash flow to put away money throughout the year and dollar cost average into something like an IRA...or invest in a brokerage account," Allen says.