A Tale of Tax Refunds and Compounding Returns
Many people are likely still waiting for their federal income tax refund in the mail, or perhaps it just arrived. There’s often temptation to spend the money on things we’ve been waiting to buy — whether a much-needed vacation or a new personal gadget.
But a much better plan can be to put that money toward the future. Investing it, for instance, in an individual retirement account allows you to set aside a nice chunk of money that has the potential to grow into a nice retirement savings fund.
Here’s how this can work:
Let’s think about a hypothetical person – we’ll call her “Rachel.” At age 35, Rachel has only $25,000 saved up for retirement in her workplace 401(k) – the national average, according to the Employee Benefit Research Institute. However, according to EBRI, the average worker today will need at least $900,000 saved up by age 65 in order to retire securely.
Rachel overpaid federal taxes through her payroll, and so Uncle Sam gave her a refund of $3,000 that it deposited in her bank account. Rachel is ready for a shopping spree. But she decides instead to put that $3,000 to help bolster her retirement savings.
After consulting her financial advisor, Rachel puts the money into a Roth individual retirement account. This means she gets no tax break for her contribution, but that $3,000 will grow tax-free and she’ll never have to worry about paying taxes on it again.
Her advisor suggests she put the money into a well-diversified mutual fund, to minimize her investment risk.
Rachel leaves that $3,000 in her Roth IRA until her retirement 30 years later at age 65. In fact, Rachel contributes every tax refund she gets for the next 30 years – for simplicity sake, we’ll assume it’s $3,000 every year. (The average tax refund amount is currently about $3,000, according to the Internal Revenue Service.)
What happens to Rachel’s retirement fund over those 30 years? Rachel herself contributed $3,000 a year, or $90,000 in all. But thanks to the magic of compounding – the ability for an investor to reinvest their earnings and start generating returns on those reinvested – that $3,000 annual tax refund grows substantially over the 30 years.
Assuming a 6% average annualized return on investment (a fairly safe assumption in a diversified account with stocks and bonds), Rachel would have a little more than $250,000 in her retirement fund after the 30 years – or roughly triple the $90,000 in tax refunds she invested.
Since Roth IRAs never require withdrawals during your lifetime, she can continue to benefit from years of compounding and that $90,000 in contributions. If Rachel does make withdrawals in retirement, that $250,000 in her Roth can be withdrawn tax-free.
Takeaways
Here are some takeaways from Rachel’s story that can help you maximize your tax refund:
Think differently. Your tax refund isn’t really a “gift” from Uncle Sam. It’s overage you paid into the tax system through your paychecks. So it’s really a portion of your income being refunded to you. While it’s OK to splurge a little bit, Rachel’s story shows how investing it can provide much greater value over many years.
Start early. Investment compounding becomes more powerful over the years. So the earlier you start investing your tax refunds, the more time they have to grow.
Consider Roth. Many people have a “traditional,” tax-deferred 401(k) plan through their workplace. But given the real possibility that federal taxes will go up and be higher when you retire, a Roth allows you to pay today’s lower tax rates on your savings so you don’t have to worry about them in the future.
Diversify. Like Rachel, make sure to spread your savings across a broad mix of investments, so you’re not overexposed to one type of stock or bond. Typically you want the majority of your savings to be in a mix of U.S. and international stock funds or exchange-traded funds while you’re still young, but slowly build your stake in bonds and other fixed-income investments as you get older and your investing horizon shortens. An easy way to diversify is by investing through a “lifestyle” or “target date” mutual fund tied to your expected retirement year that automatically becomes more conservative as you get older.
Kelly Spors writes for the leading Roth IRA and online retirement planning resource, RothIRA.com. She is a former Wall Street Journal reporter who has also written for The New York Times, Entrepreneur magazine, SmallBizTrends.com and Yahoo!. Kelly specializes in personal finance and small business issues.
The Financial Tales Response
The preceding Tale submitted by Kelly is one that readers may find timely. Many of you have recently received or will soon receive a tax refund and many may be wondering what to do with it. Remember you only have 3 choices. You can invest it, spend it or some combination of the two. Kelly provides a vivid example of what might happen if you invest it. This tale teaches us about saving vs. spending and shows us the power of compounding. In her tale Rachel only saves $3,000 per year or $90,000 total over 30 years but it grows to $250,000 if we assume a 6% interest rate. This isn’t chump change for what I consider painless investing. This might be something that works for you. You can refer to A Compounding Tale for a better understanding of the power of compounding.
I have two areas of possible disagreement with Kelly’s Tale however.
The first possible disagreement is I can’t tell from her writing if she is recommending a “Target Fund” or Lifestyle Fund” or just using it as an example. In any event–Financial Tales does not recommend these types of mutual funds under any circumstances and at any time in a person’s wealth cycle. When building wealth they are expensive, they underperform and allocate entirely too much money to fixed income way too early in a person’s life. Furthermore, if you are no longer building wealth they are still expensive, underperform and allocate entirely too much money to fixed income. We suggest you avoid these types of formulaic and expensive types of investments with your portfolio. If Kelly were to have substituted a Total Return Fund or Balanced Fund that is on our approved list we would have been much happier.
The second area of possible disagreement stems from “Rachel” consulting with her financial advisor. The advisor recommends a Roth IRA which seems like a good mechanical idea but then doesn’t take control of the situation and either a) lets Rachel do her own investing by potentially letting her invest in the dreaded Target Fund or b) may have actually recommended it him or herself. In either event it is important to our readers that they understand that you either hire a competent advsior and have a way to distinguish their competency as we learned from An Expert Tale or you must develop your own competency. It is too easy to read a Tale such as this one and assume the subliminal message of “an advisor that recommends a mechanical idea is also a competent advisor and Target Funds are OK” when in fact mechanical ideas are the least important aspect of an advisor’s job.
If you are interested in the types of investments we at Financial Tales recommend, feel free to contact us and we will get in touch with you shortly.
