The Smartest Thing You Can Do With Your Tax Refund

By Matthew Frankel Markets Fool.com

It's refreshing to know that most Americans who expect a tax refund plan on using it in a financially productive way, such as saving the money, paying off debt, or investing. However, fewer than one in six Americans expecting a tax refund plan to use their tax refund for retirement savings -- and here's why more people should.

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What Americans plan to do with their tax refunds in 2017

A recentTD Ameritrade survey found that of the Americans who expect to get a tax refund, most plan to either save the money or use it to pay down debt of some kind. Here's the full breakdown of the responses. (Note: Percentages add to more than 100% since respondents could choose more than one.)

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  • 42.3% put into general savings
  • 16.5% put toward retirement savings
  • 16% spend on day-to-day expenses
  • 15.4% spend on an experience (i.e., trip)
  • 11.5% put into non-retirement investment account
  • 9% buy something fun
  • 8.2% pay off mortgage loan
  • 7.9% pay off car loan debt
  • 6.3% put toward children's college savings
  • 5.1% donate to charity
  • 4.1% pay off student loan debt

As you can see, the most common answers were generally financially responsible uses of the money. Over 80% of survey respondents said that a tax refund is either primarily for investing in the future or for paying down debt. Just over 19% said that a tax refund is "fun money."

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What more people should do

To be clear, there's nothing wrong with using your tax refund to pay down high-interest debt, build an emergency fund, or donate money to charity. If you're expecting a tax refund and plan to do one of these things, I'm certainly not going to try to talk you out of it. I haven't gotten a tax refund in several years, but last time I did, I used it to pay off my credit cards.

However, to the 36% of Americans who say they plan to spend their refund on a trip, buy something fun, or invest the money in a non-retirement account, I'd like to suggest an alternative -- put the money in your IRA to save and invest for retirement. And if you don't have an IRA, start one. You can even have your refund directly deposited into your IRA to make the process more convenient.

Quite frankly, I was surprised that only 16.5% of survey respondents planned to use their refund specifically for retirement savings, considering the benefits of doing so -- more on that in a bit.

Investing in an IRA doesn't have to be complicated like many people think it is. There are only two main varieties of IRA -- traditional or Roth -- and you can read a discussion of the difference between the two here. For the majority of IRA investors, choosing a handful of low-cost index funds like these is an excellent way to go, especially at first.

Boost your tax refund for next year and get closer to financial freedom

I've written before that investing in an IRA is the smartest tax move you can make, and I believe this for two reasons.

First is for the tax benefits. If you're investing in a traditional IRA, your entire IRA contribution may be tax deductible, even if you don't itemize your deductions. For 2017, you can contribute up to $5,500 to your IRA ($6,500 if you're over 50), so this can be a pretty substantial tax deduction. So, by contributing to a traditional IRA, you can use the tax refund you get this year to increase the tax refund you'll get next year, and so on.

For a Roth IRA, you can't deduct your contributions, but any qualified withdrawals from the account will be tax-free, which can allow you to avoid income taxes after retirement. For taxpayers earning less than $62,000 in 2017, both types of IRA contributions can qualify for the Saver's Credit.

The second, and most important reason to contribute to an IRA is that doing so can make a big difference in your financial security later in life.

Let's say that you're expecting a $3,000 tax refund in 2017 -- about the national average, according to the IRS. If you were to deposit this into an IRA and invest in a low-cost S&P 500 mutual fund, your refund could be worth $29,000 in 25 years, based on the historical performance of the stock market. Better yet, if you were to do this every year for 25 years, your tax refunds could grow into a $247,000 nest egg just from investing your tax refunds. That's why investing your tax refund in an IRA is an option that's worth serious consideration.

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