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5 Retirement-Smart Ways to Use Your Tax Refund

If you receive a tax refund this year consider putting that money to work for you instead of spending it. You can save and/or invest that money for your future – when you don’t have a paycheck coming in. If you can keep it invested long term, you can reap the benefits when you retire, or choose to work fewer hours. Here are five suggestions for how you can use and even grow your tax refund dollars. Your future self will thank you.

1. Build an Emergency Savings Fund

Do you have the financial resources to handle an unexpected medical bill or missed paycheck? If not, you may have to incur debt or let other payments slide to handle the new expense. Often, retirement savings contributions are the first thing to fall away. An extended break in saving can take a significant toll on your future retirement balance due to fewer contributions and lost years of compounding earnings. And if you need to tap into your retirement savings early to cover a large expense or a long period of unemployment, your retirement account balance will suffer further. Having an emergency savings fund you can spend now if needed can be crucial to creating future financial security in retirement.

Emergency savings need to be safe, liquid, and accessible. But that doesn’t mean you can’t still try to grow that money. An interest-bearing savings account can provide a small amount of growth with no risk, and investments like certificates of deposit and Treasury bonds offer a little more growth potential while still being low risk and relatively liquid. 

2. Make a Tax-Deductible Traditional IRA Contribution

You can save up to $6,000 per year in an IRA and $7,000 if you’re age 50 or older. A traditional IRA offers the benefit of a current-year tax deduction for contributions and an ongoing deferral of taxes on investment earnings until you withdraw those funds – ideally in retirement. The dual benefits of saving in an IRA make it a great way to bolster your retirement savings, even if you already participate in a retirement plan at work.

Example: By saving $6,000 per year in a Traditional IRA from age 35 to 67, you would have contributed a total of $192,000. But with an average return of 7% per year, your contributions could be worth $601,460 in retirement income after taxes are paid.*

An IRA allows for a broader range of investment options than most employer plans, and IRA assets may be accessed at any time if you need a safety net. You will have to include your withdrawal in your taxable income for the year, and it will be subject to a 10% early distribution tax if you’re younger than 59½ at the time of withdrawal, unless you meet an exception to the additional tax.

3. Make a Roth IRA Contribution for Tax-Free Growth

Although saving in a Roth IRA doesn’t give you the benefit of a tax deduction, investment earnings are still tax-deferred until you withdraw them and will be tax-free if you meet the conditions for a “qualified” distribution. Tax-free investment growth and tax-free withdrawals in retirement are both important retirement income strategies and the longer time horizon you have to save in a Roth IRA, the greater the benefit can be.

Another benefit of a Roth IRA is that the tax laws allow you to remove your contributions tax-free at any time. Some save in a Roth IRA because they know they can access their savings at any time and for any reason without tax consequences. Some people even use a Roth IRA as an alternative education savings plan, so they are not locked into using their savings for education (as with a 529 plan). Seek financial planning advice to discuss this strategy, so you understand how it affects financial aid and the hit to your retirement account balance. 

4. Diversify Your Investments

Tax benefits aside, saving in a self-directed IRA also enables you to diversify your investment portfolio. Diversifying your investments lowers your volatility risk and allows you to benefit from growth in a variety of market sectors. A self-directed IRA opens your options to a wide variety of investments that are not typically tied to the stock market. For example, you could invest in real estate, such as single-family housing, mortgages, or commercial development. Or you could invest in private equities, such as investing in a start-up company or helping to support the expansion of an existing company. You can put your money “to work” in many ways beyond just growing your initial investment.


5. Pay for Financial Planning Advice

What could be even more valuable than a contribution to your savings is an investment in expert financial advice. Understanding investment risk and return, guarding against inflation risk, outliving your savings, etc. is complex. A financial professional will have the expertise not only to help you understand the different investments available, but also to help you design a comprehensive financial plan. This can include personalized advice on how much to save for short-term needs and retirement and which types of accounts you can use to meet your tax objectives now and later and even after your death. A financial professional can also help you design an investment strategy to help you meet your savings and investment goals. Once you have a strategy selected, they can also help you over the years to monitor your investments and adjust them as needed according to the market and your changing needs as you age.

* https://www.stratatrust.com/calculators/Assumptions: 25% income tax rate while working, $100,000 adjusted gross income, married filing joint tax status, participant in employer plan, fully deductible contributions, 7% expected rate of return, 15% income tax rate in retirement

Tags: 2020 IRA Contributions, IRA, tax strategy