In 2018, the average federal tax refund in America was $2,895 and almost 8 out of 10 Americans received one. Even though it’s right there in the name, tax refund, meaning a refund of your own hard-earned money, people still treat it like “free” money. It’s not a gift or a stroke of good fortune.
Where does the refund come from?
A refund occurs when your taxes are overpaid each pay cycle. So you’ve essentially just loaned the U.S. government your money — without making interest on the loan. To make sure that doesn’t happen next year, use the IRS withholding calculator to adjust your deductions. Your pay will be greater each month and, in turn, you can add that extra into your everyday spending, invest on a regular basis, or bulk up your savings accounts on a monthly tempo. Regardless of what you do with the dollars, it’s better than all that missed interest.
What should you do with a tax refund?
For the people who get a refund, lots choose to spend it on a luxury purchase, a vacation, or use it to pay off holiday credit card debt – all totally fine options for how to spend your own money! But what if there were a better option available? One that took that $2,895 and turned it into $30,000?
The magic of the IRA
If you’re making the match (you should be!) on your workplace retirement plan — or don’t have one — an IRA is the first stop on the road to retirement success. There are a few types of IRAs and they all have different rules and benefits.
You get to contribute now, tax-free, and then the money is taxed when you withdraw it.
The tax-free nature of contributions gives you a larger principal amount in your account, which means you’ll have a larger sum of money accruing compound interest. It’s important to remember that you will have to pay taxes on the money, eventually, when you withdraw it.
What Are the Limitations?
You can contribute a maximum of $6,000 each year (if you’re over 50, that number gets bumped up to a $7,000 max). If you take money out before you’re 59½, you’re going to have to pay a 10% fee.
Who Should Get a Traditional IRA?
Traditional IRAs are great if you’re established in your career, and you don’t anticipate moving up in a tax bracket before you’re going to be taking your money out (this will make more sense once we explain Roth IRAs).
With a Roth IRA, you contribute money that has already been taxed, and then pay no taxes when the money is withdrawn.
The biggest selling point of a Roth IRA is the potential tax savings. If you’re in a lower tax bracket now, and you anticipate being in a higher tax bracket when you retire, this is ideal.
What Are the Limitations?
The maximum you can contribute to a Roth IRA each year is $6,000 (again, if you’re over 50, you can contribute up to $7,000). It should also be noted that Roth IRAs have income limitations, so if you make too much money, this one is going to be off the table.
And like a Traditional IRA, if you withdraw before you’re 59½, you’ll have to pay a 10% fee.
Who Should Get a Roth IRA?
Anyone who is at the beginning of their career or single but planning to marry. Basically, if you’re going to be retiring in a higher tax bracket than you’re in now, max out that Roth IRA.
Reading this article thinking, “When I decided to venture out and start my own business, I said goodbye to the security of a retirement savings account”? Well, then this option is going to speak to your self-employed heart.
An SEP, which stands for Simplified Employee Pension, functions the same way as a Traditional IRA, except that it’s designed for people who are self-employed and their employees. The short version is: you can contribute money tax-free, and then you pay taxes when you withdraw the money.
An SEP IRA allows self-employed individuals to enjoy the benefits of retirement savings accounts while minimizing the fees. If you’re self-employed or work for someone who is, this is a great way to take care of your retirement in a way that won’t bombard that small business with fees.
What Are the Limitations?
This is where it gets a little complicated. In the same way that Roth IRAs have restrictions on how much you can earn to be eligible, SEP IRAs have more complicated rules on how much you can contribute.
The maximum amount you can contribute to an SEP is 25% of earnings, or $56,000, whichever amount is less. If you’re self-employed and you also employ others, then you can make that same max contribution on their behalf.
Otherwise, SEPs operate like a Traditional IRA. You make the contributions tax-free, and then when you withdraw, the money is subject to tax. If you withdraw before age 59 ½ without a qualifying reason, you are subject to a 10% fee.
Who Should Get an SEP?
If you’re someone who has embraced the gig economy, works as a creative professional, are starting a new business, and/or have to juggle what feels like a million 1099’s at the end of the year, this one's for you. If you’re someone who is employed and also employs a small number of people, this is a great way for you to provide them something comparable to employer-matching 401(k)s because you can contribute up to 25% of net income for them.
Now that you have the information to figure out which IRA is right for you and your needs, invest that tax refund into an IRA that can make an impact -- for your future financial health and the health of our present world.
Calculations made here with a one time contribution of $2,895 growing for 35 years at 7% and a tax rate of 25%.