Smart Ways to Invest Your Tax Refund in 2021

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This story originally appeared on SmartAsset.com.

Tax season began on Feb. 12, and millions of Americans are eagerly expecting a tax refund. They might be in for a tidy sum: The IRS says that the average tax refund in 2020 was more than $2,500.

With the COVID-19 pandemic still wreaking havoc on many households’ finances, some taxpayers will use their refunds on essentials — to pay their bills, to pay down debt or simply to sock away money for an emergency. Others might think about investing it in their future.

Let’s take a look at a few smart things you can do with your tax refund in 2021.

Immediate Needs: Bills and Debt

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First things first: If you’ve got bills and other pressing financial needs, these are the priority.

Dealing with pressing financial matters, like paying for rent, utilities and other necessary bills, should always be a priority. This is key to remaining financially stable, and an effective strategy to safeguard against debt.

Next, if you’ve got a significant amount of debt — particularly high-interest debt — then you should use your tax refund to pay down this debt.

Credit card debt, which typically has high interest rates, will likely be the top priority. Paying off other types of debts, like student loans and mortgages, may or may not be a priority depending on the interest rate you’re paying on that debt.

If your emergency fund has been depleted during this economically challenging time, you should use your tax refund to rebuild it. This could help protect you against unexpected emergencies like the sudden loss of employment or additional health expenses.

Boost Your Retirement Plan

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If you don’t have any pressing needs or high-interest debt, then putting your tax refund toward retirement is a great move for your long-term finances. Years of investing returns in a tax-advantaged retirement account can turn a modest tax refund into a significant amount of retirement income.

A Roth IRA, for instance, is a popular retirement plan for young investors who are starting out in their careers.

While you pay taxes when you put money into this individual retirement account, withdrawals made over age 59½ are tax-free. Note that in 2021, you can contribute up to $6,000 to a Roth IRA ($7,000 if you are age 50 or older).

By comparison, you can also invest your tax refund in a traditional IRA. Unlike a Roth IRA, you will be taxed after retirement when you take money out, but you get to take a deduction on your taxes for any money you put in.

Both traditional IRAs and Roth IRAs have the same contribution limits in 2021. Keep in mind, however, that you will have to make required minimum distributions (RMDs) for your traditional IRA when you reach age 72 (or 70½ if you were born before July 1, 1949).

If you are a taxpayer with a 401(k) plan, then using your tax refund to boost your pre-tax contributions is another smart way to maximize your retirement savings.

While 401(k) contributions are deducted from your paycheck, what you pay now will compensate you more in retirement. Especially if your boss matches those contributions, which essentially means that you are getting free money for every payment that you make into your retirement plan.

SmartAsset’s retirement calculator can help you figure out how much money you will have when you retire.

Invest in Stocks

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Whether you put your refund in a retirement account or a regular brokerage account, investing it in the stock market will pay off in the long run.

While stocks can be more volatile in short intervals than other types of securities, experts say that it delivers higher returns on long-term investments. That is why many first-time investors work with financial advisers to create a plan for their investing goals.

Stocks are equities or shares of a company that you ideally want to buy at an affordable price and hold on to them over time so you can sell them for a higher profit. If you have a 401(k) plan, then you are most likely already invested in stock through your employer.

You can buy individual stocks or bundles of stocks (either in the form of mutual funds or exchange-traded funds) through traditional investment brokers, online brokers and do-it-yourself robo-advisers.

Your success will largely depend on your time horizon, which is how long you intend to hold on to an investment and how much risk you are willing to take on to grow your money.

If you’d like to invest but aren’t comfortable with the risk in the stock market, consider bonds, either corporate or government, or bond funds. Also known as fixed-income securities, these are essentially debt instruments that are publicly traded. If you’re not sure how to invest in fixed-income securities, consider a bond index fund.

Seed a 529 College Savings Plan

529 plan
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If you want to lessen the financial burden of higher education, then investing some or all of your tax refund in a 529 savings plan is a smart way to pay for the rising costs of college and safeguard against mounting student debt.

Taxpayers can get state income deductions or credit for their 529 contributions. And withdrawals aren’t taxed as long as they are used for qualifying expenses like paying for college tuition, books and school supplies, and on-campus room and board.

If you are a parent, then you might want to consider investing in a 529 plan for your child. However, you can also benefit from this plan if you intend to go back to school as an adult or further your education through a graduate program.

There are many types of plans and diverse investment portfolios to help fund your education goals. The U.S. Securities and Exchange Commission says that all 50 states and the District of Columbia offer at least one type of 529 plan.

In order to maximize the use of your 529 plan, and the tax refund money that you are investing in it, you will need to project the annual tuition of the college, additional monthly contributions, and other variables that will impact how much you have to save.

Invest in Your Health Savings Account

Health savings account
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Investing your tax refund in a health savings account (HSA) is a smart choice if you want to set tax-free money aside to pay for future medical expenses. And, if you don’t end up needing the money, you can also use your HSA to save during retirement.

You should keep in mind that taxpayers can only qualify for an HSA if they are enrolled in a high-deductible health plan (HDHP). The IRS defines an HDHP in 2021 as a health insurance plan with a minimum annual deductible of $1,400 for individuals and $2,800 for families. It has a maximum out-of-pocket cost of $7,000 for individuals and $14,000 for families.

The money that goes into your HSA is tax-free, which means that your contributions will not be taxed. And you can also take out that money tax-free as long as it’s used for qualifying medical expenses.

Furthermore, your gross income is lowered when you put money into your HSA. So if you earn $45,000 that tax year, and you put $3,000 into your account, then your gross income will be $42,000 when your taxes are filed.

Note that HSA contribution limits for 2021 are $3,600 for individuals and $7,200 for families. And your contribution limit increases by $1,000 when you are age 55 or older.

Another advantage of funding an HSA is that you can use it as an additional source of income during retirement. When you take out HSA funds to pay for expenses outside of health care, you get taxed for that withdrawal and the IRS imposes an additional 20% penalty. But, if you are age 65 or older, that penalty gets waived and you are taxed at the regular rate.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act also expanded eligibility for tax-free HSA withdrawals to cover additional expenses outside of insurance. So your tax refund could now boost your account to pay for aspirin and allergy medication without a doctor’s prescription, as well as menstrual care products for women, and other over-the-counter drugs and medications.

Work With a Financial Adviser

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A financial adviser can help you invest your tax refund. Financial management often requires big-picture insight, and an adviser could use that expertise to address your financial needs specifically.

Before you spend your tax refund, an adviser will help you create a financial plan to map out the areas where you can benefit most.

These could include maximizing your retirement income for Social Security, managing investments to identify new opportunities, planning your estate to take care of family or optimizing a tax strategy for your finances, among other important decisions.

Whether you are starting out on your career, or just a few years away from retirement, the good decisions that you make today will pay off at a greater scale in the future. And a financial adviser is a smart choice to help turn your tax refund into an important step for your goals.

A tax refund can be a much-anticipated boost for your finances. But if you don’t need the money for anything urgent, you can invest it in a smart way for your future. Whether you plan on saving for retirement, make your money grow in the stock market, finance your education or save for health expenses, working with a financial expert can help you set and reach these financial goals.

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