5 Simple Steps to Triple the Value of Your Tax Refund

By Markets Fool.com

According to the IRS, the average refund taxpayers received during the 2016 filing season was $2,732. That's a substantial chunk of change, but what if I told you that you could take that money and potentially triple its value for you by the end of this year?

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Indeed, you can turn that average refund into over $8,000 toward your retirement by the end of this year, with absolutely no impact to your lifestyle. All you need to do is follow these five simple steps.

Step 1: Contribute your refund check to your IRA

For 2016, if you or your spouse are working, you can potentially contribute up to $5,500 each to either a Roth IRA or a Traditional IRA. If you're age 50 or up, that potential contribution increases to $6,500.

  • your taxable compensation for the year, if your compensation was less than this dollar limit.

A refund check of $2,732 fits easily within those limits, which makes it a straightforward way to turn your tax refund into money for your retirement.

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Step 2: Increase your contributions to your traditional 401(k) or equivalent plan at work

Your tax refund isn't a gift from the Government. It's the return to you of an interest-free loan you handed Uncle Sam during the year by over-withholding your taxes. Take that money back and put it to productive use for yourself. You can contribute pre-tax money to your traditional 401(k) and get not only your money working for you but also money Uncle Sam would have otherwise taxed from you.

To fully make use of your refund check, increase your 401(k) contributions by enough to make up for both the refund itself and the tax you won't be paying on the contributed income. The basic math is Refund / (1-marginal tax bracket). If you're in the 25% tax bracket and got that typical refund, that would turn into $2,732 / (1-0.25) = $3,642.67.

Step 3: Adjust your withholding at work to get it closer to break even

In step 2, you invested the money that you had over paid Uncle Sam, but in doing so, you did decrease your take home paycheck. Key to making this plan neutral to your everyday lifestyle is to decrease the amount Uncle Sam withholds every paycheck. Using IRS Form W-4 or your employer's substitute, you can adjust your withholdings to make it so you won't be making another large interest free loan to Uncle Sam this year.

When you're making this adjustment, your objective should be to get close to break even when it comes time to filing your taxes next year. If you reduce your withholdings too much, you could have to pay underpayment penalties on top of any taxes you owe. The key is to be within one of the IRS' "Safe Harbor" limits. For 2016, the key Safe Harbor limits are:

  • If you owe less than $1,000 in taxes for 2016 when it comes time to file in 2017
  • You've paid at least 90% of what you owe for 2016 (66 and 2/3% for farmers and fishermen)
  • You've withheld or paid via timely estimated tax payments at least 100% of what you owed for 2015 (110% if your income in 2015 was above $150,000 or if it's above $75,000 and your filing status is "married filing separately")

Step 4: Thank your employer for its 401(k) match

Many employers offer a match to encourage employees to contribute money toward their own retirement. Matches vary by company, but a common practice is a $0.50 match for every $1.00 the employee contributes, up to some percentage of salary. On that $3,642.67 contribution you made in step 2, a 50% match would be an additional $1,821.33, contributed into your retirement account, on your behalf.

Step 5: Count your cash

Your $2,732 IRA contribution from your refund check plus your $3,642.67 contribution to your 401(k) plus your employer's match of $1,821.33 brings your total to $8,196. That's triple your original refund amount, now working on your behalf to help fund your retirement.

Perhaps best of all, you just figured out how to save that $8,196 with no impact to your everyday lifestyle. Every penny of that money came straight from your tax refund this year, from the money that would otherwise have been a tax refund next year, and/or from your employer's matching program.

How often can you come up with $8,000 that easily?

As fun as it might be to hold that $2,732 refund check, wouldn't it be even more fun to see it turn into more than $8,000 this year? On top of that, once you've taken these five steps, that $8,196 will be in your retirement accounts, where it can grow tax-deferred on your behalf for the rest of your career.

That's an amazing opportunity available to you simply by choosing to no longer offer Uncle Sam an interest free loan, instead putting that very same stack of your own money to work for you. So get started today, and turn that tax refund into the foundation for your financial future.

The article 5 Simple Steps to Triple the Value of Your Tax Refund originally appeared on Fool.com.

Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.