6 Ways Your Tax Refund Can Improve Financial Independence
Tax Refund Tip #1: Pay Down High Interest Rate Credit Cards and Loans
If you have high interest credit card or student loan debt, one of your first financial priorities should be to pay it down. While there’s set of guidelines, it’s smart to pay down any debt that has an interest rate higher than 6-8%. Currently, CDs pay less than 1%. The 10 year government bond yields less than 2%. Many professional advisors believe that the long term US equity markets return is in the 5-6% range. With this as a backdrop, it makes sense to pay down debt with interest rates higher than these returns. Other than short term teaser rates, most credit cards charge at least over 10% on ongoing balances.
Paying down debt may not increase your asset level, but it certainly increases your net worth (assets minus liabilities). For most people, paying down debt lowers stress level and is an important step toward achieving long term financial goals and a building block for financial independence.
Tax Refund Tip #2: Fund Your 401K
By contributing more to your 401K, you are helping your financial future while lowering your taxes. And if your current contribution level is below the employer match rate, then there’s even more reason to use your tax refund to increase your 401K contribution. The additional 401K contribution will lower your taxes and is a good starting point for wealth building and financial independence.
Tax Refund Tip #3: Fund Your IRA / Roth IRA
If you’re currently maxing out the 401K contribution or to the employer match limit, then consider using the tax refund to fund a traditional IRA or Roth IRA. A traditional IRA, like a 401K, is made with pre-tax funds, which means the contribution lowers your taxes. There are income limits to how much of an IRA contribution is tax deductible. Please refer this IRS link to see the limitations.
While a Roth IRA is not tax deductible, its distributions are tax free when made once you’re retired. Whereas with a traditional IRA you save on taxes now, with a Roth IRA you save on taxes later. Given the US government’s debt, there’s a good chance that taxes will go up in the future, which makes a Roth IRA more attractive for people who expect to be in a higher tax bracket as their income / assets grow over time. While funding a Roth IRA may not bring immediate gratification, it takes you one step closer to financial independence.
Related: Check out this article at article at tools4retirement-blog.com for more ideas: http://www.tools4retirement-blog.com/how-taxes-kick-started-our-financial-freedom/
Watch this video with Morningstar’s Christine Benz on smart ways to invest your tax refund.
Tax Refund Tip #4: Invest In Books or Classes To Learn a New Skill
If you have no high interest debt and have been contributing to your 401K / IRAs, considering spending a few hundred dollars on books or classes to help learn a new skill. Before you spend the money, see if this is something that your employer can pay for. Also check your local library and various online resources to see if you can get this free. If you cannot, then consider shelling out the funds that will keep you sharp and interested intellectually. There’s nothing wrong with pursuing subjects “just for fun,” but if there’s something that can enrich you intellectually / emotionally while providing a skill that can enhance your professional skills and knowledge, that’d be even better. Consult your manager and recruiters to see which topics might be worthwhile.
Related to this point is the possibility of returning to graduate school for an advanced degree that can boost your knowledge and promotional possibilities. Of course, the tax refund from a single year probably won’t pay for the entire tuition, but considering saving the refund for several years and that maybe enough to pay a meaningful part of the tuition to avoid incurring student loans.
Related: How to Lower Your Investing Costs
Tax Refund Tip #5: Start An Online Business
Yes, millionaires are made online all the time. People as different as Craig Ballantyne (earlytorise.com), John Chow (johnchow.com), Michelle Phan (Youtube), and Jenna Marbles (Youtube) have leveraged the internet to make good money for themselves. In the case of Michelle Phan (link to yahoo story), she started her online make-up how to videos and is now estimated to be a $100 million brand, having started with from a borrowed laptop in her local community college.
To start, you can read successful blogs, watch free videos at Youtube, and learn the basics of blogging and online marketing before getting started. For a couple hundred dollars, you can register a domain name, get hosting services, have a website build (or do it yourself), and get started. Eventually, you’ll likely need to improve on an improved site and maybe some online marketing ads, but you can easily get started on a few hundred dollars. See Additional Resources below for ideas.
Tax Refund Tip #6: Invest in A Stock Dividend Fund or ETF
To be financially independent, one needs to have sufficient (passive) income to cover all the expenses. Tip #1 covered lowering expenses; tips #2-3 covered long term investing; tip #4 discussed improving your skill sets to earn more from your job; and tip #5 touched on starting an online business on shoe string budget. Well, Tip #6 is about investing in dividend paying stocks or funds that invest in such stocks. Numerous academic studies have shown that over long periods of time, the majority of a stock’s total return comes from dividends. Since it’s more likely that your tax refund be several hundred to several thousand dollars, it probably makes more sense to invest in a dividend fund or ETF (vs individual dividend paying stocks).
For dividend growth funds, check out the Vanguard Dividend Growth Fund (VDIGX) and Dividend Growth Fund (PRDGX). Several ETFs worth considering are the Vanguard Dividend Appreciation (VIG), SPDR S&P Dividend (SDY), and the PowerShares International Dividend Achievers Portfolio (PID). They focus on stocks that have seen their dividends increase in recent years. Over time, investors could be better off holding stocks whose dividends may start at lower levels but are growing, vs. those that have dividends of 4-5% but are growing more slowly and could even see dividends lowered if business prospects soar. In any event, these funds and ETFs select stocks with growing dividends – something you should target.
How to Start a Business Online by Entrepreneur