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Why an IRA is the Best Use of Your Tax Refund

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tax-money-my-personal-finance-journeyThe following is a post by MPFJ staff writer, Kevin Mercadante, who is a freelance professional personal finance blogger for hire, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry.

The 2015 tax season came to an end on April 18, or at least for those who do not need to file for an extension. Now comes the blessed tax refund process. And with that, comes decision time – will you spend the money on something that you need or want right now, or will you invest the refund to improve your long-term financial picture?

It’s a more important question than most of us think. According to the IRS, the average federal income tax refund for the 2014 tax year was $3,120. While that isn’t the kind of money that could change your life today, it could have a major positive impact if you handle it as part of a long-term strategy.

Investing your tax refund in an IRA could represent just such a strategy. Here are five reasons why an IRA is the best use of your tax refund.

Turning “Found Money” into a Long-term Asset

If you choose to spend your tax refund immediately, you can certainly get a “short-term high”. It could be spent on a much desired vacation, a room full of furniture, or even used as the down payment on a new car.

As exciting as those options would be, every one of them would have zero value after a few years, including a new car (since cars depreciate all the way down to near zero). But if you choose to invest the money, it will become a long-term asset, and part of your financial portfolio for potentially the rest of your life.

While it’s always fun to spend money in the short run, it’s your ability to invest for the long term that ultimately determines your financial future. Investing your tax refund in an IRA will turn a temporary windfall into a permanent asset.

Making a Contribution While You Have the Money to do it

We all have good intentions when it comes to saving and investing money. But sometimes reality gets in the way, and the planned savings strategy never happens. If you always desire to invest for the future, but never seem to have the cash to do it, receiving your tax refund is the best time to make it happen. The money will be available, and all you have to do is transfer it into an IRA account.

One of the big advantages of depositing a tax refund into an IRA is that it represents a way to kickstart your savings and investment plan. With your tax refund safely squirreled away in an IRA account, you may then have the motivation to continue funding it, all the way up to the maximum contribution of $5,500.

Converting a Windfall into a Perpetual Cash Flow

We’ve all heard the term the gift that keeps on giving, and that’s basically what an investment plan does. You are investing cash now, to create more cash later. That is a form of creating a perpetual cash flow.

In the case of making an IRA contribution with your income tax refund, if that amount of the refund is the IRS average of $3,120, and you invest it in your IRA at 8%, the account will provide you with cash flow of $250 over the first 12 months. And because of compounding of interest, future cash flow amounts will be higher in each succeeding year.

We can think of using your tax refund to fund an IRA as a way of converting cash into a cash flow. Millionaires learn that strategy early in life, and that’s largely how they become millionaires.

Getting a Jump Start on Early Retirement

It doesn’t matter how young you are, almost everybody thinks about and dreams about early retirement. Putting your income tax refund into an IRA each year could make that dream a reality in your life.

Let’s say that you are 25 years old, and for the next 30 years you commit to moving your annual tax refund – averaging $3,120 per year – into an IRA, instead of spending it now. At an average annual rate of return of 8%, your contributions will grow to $366,230 by the time you’re 55 years old.

Even if you are not making a serious effort to retire early, accumulating that kind of money well before traditional retirement age could create the opportunity to do just that. The accumulation of large amounts of money has a way of turning dreams into reality.

For what it’s worth, if you continue with the same pattern of investing your tax refunds each year until age 65, you will have $837,495 for the effort. That kind of IRA could make retirement a reality in your life, even if you have no other retirement savings available at the time.

Setting Up Another Tax Deduction for Next Year

Earlier we talked about using the cash from your income tax refund to create a cash flow; but you can also use it to create another tax deduction. If you are eligible to make a tax-deductible IRA contribution, then the amount of the tax refund going into your IRA will create a new deduction for the current tax year.

If you are in the 25% tax bracket for federal tax purposes, and say, 7% for your state, depositing a $3,120 tax refund into an IRA can reduce your tax bill by $998 (32% X $3,120). That’s like getting a 32% return on your tax refund just for putting it in the right place. Or using your tax refund from this year to build an even bigger refund next year.

How about you all? Can you think of a better place to put your 2015 income tax refund? What do you have planned for your refund?

Share your experiences by commenting below!

***Photo courtesy https://www.flickr.com/photos/pictures-of-money/16687016624/sizes/q/


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