For the fiscal year 2019, the IRS issued over $452 billion in tax refunds to nearly 122 million Americans. Who largely spent it on passing pleasures rather than investing toward improving their lives long term. With tax day rapidly approaching on May 17, many Americans have already filed and started receiving their refunds. So, what’s the best way to use your tax refund to build wealth?
Ways to Use Your Tax Refund to Build Wealth
Wherever you are on the journey to financial independence, consider these ideas to get the most long-term mileage out of your tax refund.
Pad Your Emergency Fund
Everyone needs an emergency fund.
From medical emergencies to broken down cars, roof repairs to plumbing problems, life throws curveballs at us all the time; curveballs that cost money to bat away.
If you don’t have at least $1,000 in your emergency fund, start here. Ultimately, aim for between two and six months’ worth of living expenses in your emergency fund. The exact amount depends on how stable your income and expenses are — people with secure, steady incomes and living expenses need less in reserve than those with irregular incomes or expenses.
Even so, people carrying high-interest debts should tackle them before filling up their emergency fund in full.
Pay Off Unsecured Debts
It’s hard to build wealth while paying double-digit interest rates on debts.
If you carry credit card balances from one month to the next, start by paying them off first. Credit cards charge notoriously high interest, so you should pay them off in full every month.
Beyond dodging interest charges, eliminating your credit card debt ranks among the fastest ways to improve your credit, according to Credit.com.
Once you’ve paid off your credit cards, shift your gaze to other unsecured debts. Start knocking out student loans, personal loans, and any other unsecured debts. Use the debt snowball method: funnel all your extra savings into paying off your smallest debt first, then the next smallest, and so forth until you’ve paid all your unsecured debts in full.
These debts cost more in interest than secured debts such as auto loans and mortgages because they come with a higher risk of default. Get out from underneath their yoke so you can start investing to build real wealth.
Advance Your Career Qualifications
We work in a knowledge- and skills-based economy. With higher skill sets come higher paychecks.
That means that success requires investment in yourself—investments such as new career certifications, licenses, or degrees.
Plan out exactly where you want your career to go, so you can then map precisely how to get there. Your tax refund can help cover the initial costs, getting you over the hurdle so you can negotiate a higher salary or qualify for a new job.
Invest in your career, whether to earn more in the future or simply to switch to more fulfilling work.
Put It Toward a Down Payment on a Home
While there’s nothing wrong with renting — it certainly allows more flexibility — homeownership comes with financial perks not available to renters.
First of all, home values and rents have skyrocketed far faster than wages in the US. Between 1960 and 2017, rents rose 72%, and home prices jumped a whopping 121%, according to a 2020 study by Clever Real Estate. Meanwhile, real incomes only lifted by 29%. All of those figures represent inflation-adjusted dollars.
Speaking of which, owning a home protects against inflation, as the monthly payment gets locked in place even as the value of the dollar diminishes over the next 15-30 years—a period over which you can expect rents to continue skyward.
Moreover, many homeowners can claim a mortgage interest deduction and have the freedom to modify their homes however they see fit.
Homebuyers can also get creative and house hack. In the classic house hacking model, homeowners buy a multifamily property with two to four units, move into one, and rent out the other(s). The rental income covers their mortgage payment, and they effectively live for free.
But that’s not the only way to house hack.
Add an Income Suite
Clever homeowners can house hack a single-family home by creating an income suite on the property they rent to a tenant.
These could include a standalone accessory dwelling unit, a basement or garage apartment, or any other section of your home with its own entrance, bathroom, and kitchen or kitchenette.
Even if the rent doesn’t cover your entire mortgage payment, you can still knock out the majority of it.
Don’t like the idea of a permanent tenant? Rent out your suite, or even a bedroom, short-term on Airbnb. A friend of mine rented out a bedroom and attached bathroom in her apartment, typically for just a weekend or two each month. The revenue she earned covered the bulk of her rent payment.
Put It Toward a Down Payment on a Rental Property
No one says you have to rent out your own home to generate rental income. Why not create a passive income stream that keeps paying out indefinitely?
Rental properties come with a slew of benefits beyond ongoing income as well. The income adjusts for inflation as your mortgage payment stays fixed even as rents rise. They come with plenty of above-the-line tax deductions, which means landlords can still take the standard deduction on their personal return.
Best of all, investors can buy these income-producing assets mainly with other people’s money. With a rental property loan, investors typically come up with a 20% down payment. The lender covers the rest.
Your tenants can pay off the mortgage for you. And when they do, your monthly cash flow will take off.
Flip a House
Rather than keeping an investment property as a rental, buyers can flip it for a fast profit instead.
By now, everyone knows how flipping works. Investors buy a run-down property, renovate it to force equity, then sell it to a homebuyer.
However, flipping houses does come with its share of risks and pitfalls that they don’t show on TV. Be careful not to underestimate the renovation costs or carrying costs. Contractors are notoriously difficult to work with, often hitting owners with surprise changes in costs or timetables halfway through the job. Please keep a close watch on contractors, and incentivize them to complete jobs on-budget and on-schedule.
Budget in a buffer to cover unexpected expenses. As a novice real estate investor, you’ll have more than your fair share.
Invest in Tax-Sheltered Retirement Accounts
Every American below a certain income level can contribute to an IRA or Roth IRA. Some can also contribute to employer-sponsored retirement accounts such as 401(k)s, 403(b)s, and SIMPLE IRAs.
If your employer matches your contributions, take them up on that offer. Tax benefits aside, you get an instant, 100% return on your investment when your employer matches it dollar-for-dollar. It amounts to effectively free money.
Beyond that, consider investing in a Roth IRA. It’s more flexible than a traditional IRA and allows account holders to withdraw contributions any time, tax-free. Many Americans should also expect to owe higher taxes in retirement than they pay today, making Roth IRAs a great way to protect against both future tax hikes and higher taxes due to their own growing wealth.
For that matter, employees can contribute to a Roth version of their 401(k) or 403(b) as well.
Invest in Tax-Sheltered Education Accounts
Beyond retirement, many parents also want to help their children with college education costs.
Fortunately, they can do so with other types of tax-sheltered accounts.
Consider starting with an education savings account (ESA), which is regulated at the federal level. That makes the rules straightforward for all Americans. These accounts work like Roth IRAs, where contributions are taxable, but the money grows tax-free, and you pay no taxes on withdrawals (when used for education expenses). Parents can contribute up to $2,000 per year.
Alternatively, parents can contribute to a 529 plan. These operate at the state level, so the rules and advantages vary by state. Note that 529 plans come in two primary varieties: investment accounts (similar to ESAs and Roth IRAs) and prepaid tuition plans. In the latter, parents pay a flat tuition amount upfront, years before their child reaches college age. The child can then attend without spending another cent in tuition.
Invest in a Taxable Brokerage Account
As nice as it is to minimize your tax bill, that isn’t the primary goal of investing. You invest money to build wealth and passive income streams, which in turn enable you to achieve your long-term goals.
Besides, investors can only withdraw money from retirement accounts after age 59 ½ in most cases. Where does that leave people (like me) who want to retire in their 40s?
Everyone should have a taxable brokerage account in addition to their tax-sheltered accounts. These accounts let you invest in blue chip stocks, bonds, and other assets, mainly for free. Many brokerage firms no longer charge commissions on trades — try Schwab or TD Ameritrade for free investing.
Nor do investors have to plan their portfolios. Use a free Robo-advisor to propose and automatically manage your investments. I use Schwab, but SoFi Invest offers a strong free Robo-advisor service as well.
Invest for Passive Income
Rental properties aren’t the only way to generate passive income. Investors can also create income streams from equities, bonds, REITs, and other less mainstream investments.
Among equities, investors can earn passive income from dividend-paying stocks, mutual funds, or exchange-traded funds (ETFs). You can search out funds and individual stocks that generate high dividend yields, such as the NOBL dividend aristocrats fund. If diversification and growth are more important to you, consider investing in stock index funds, which mirror major stock indexes like the S&P 500.
Investors with lower risk tolerance can turn to bonds. To reduce your taxes on the income and boost your effective returns, explore municipal bonds with tax advantages.
Real estate investment trusts (REITs) and REIT ETF’s allow you to invest in real estate from the comfort of your brokerage account without those pesky 10 pm phone calls from tenants complaining about burnt-out light bulbs. Under SEC regulations, publicly traded REITs must payout 90% of their profits in dividends. That creates high dividend yields but limited growth potential, as these funds have little flexibility to reinvest their profits in more properties.
Invest in Real Estate Crowdfunding Platforms
Increasingly over the last decade, non-accredited (non-wealthy) investors can participate in real estate crowdfunding investments.
In some cases, they offer private REITs: funds that either own properties or lend money against properties. In others, investors can pick and choose individual real estate loans to fund. But in both cases, investors can typically expect strong income yields.
These private investments don’t trade on stock exchanges, unlike publicly traded REITs. Instead, investors buy directly from the crowdfunding platform itself. I’ve mainly had positive experiences with Streetwise, Fundraise, and GroundFloor, although do your homework on whether they’re a good fit. Many real estate crowdfunding investments require long-term commitments, often five years or longer, so don’t invest money you might need in the foreseeable future.
Crowdfunded investments don’t fall under the same SEC regulations as publicly traded REITs, which frees crowdfunding platforms to reinvest more of their capital into growing their portfolio rather than paying out 90% of their profits in dividends.
Start or Grow a Business
The wealthiest people in the world aren’t doctors or lawyers. They’re entrepreneurs who started their own businesses.
Consider putting your tax refund toward starting or growing your own side hustle business. Don’t be afraid to start small, such as doing freelance work or launching a blog or web-based business. Such companies require almost no startup capital, and you can start working them on the side of your full-time job.
If you already have a business, consider investing your tax refund into growing your business. Try new marketing strategies. Outsource low-skill tasks to virtual assistants to free up more time for high-level work only you can do. Expand into a new product market or geographic area.
Who knows? Your side gig business could evolve into a full-time gig sooner than you expect.
Change Health Insurance Plans
If you aren’t happy with your health insurance plan, there’s no better time to change it.
That could mean a more comprehensive policy with higher premiums and lower deductibles. For some households with barebones coverage, an upgrade could go a long way in protecting them from expensive health crises.
Alternatively, some healthy households are better off with a lower-cost, high-deductible healthcare plan combined with a health savings account (HSA). After all, HSAs offer the best tax advantages of any tax-sheltered account. Plus, they leave you with more control over your healthcare spending. But only if you contribute enough money into your HSA each year, rather than spending your savings on the premium. For the tax year 2020, the maximum contribution is $3,550 for individuals, $7,100 for families. (Those numbers rise to $3,600 and $7,200 respectively for the tax year 2021).
Regardless of how you define a “better” healthcare plan, your tax refund could help you switch to a plan that better fits your needs.
Buy Life Insurance or Long-Term Disability Insurance
Not everyone needs life insurance or long-term disability insurance. But traditional “breadwinner” households often do.
Life insurance works best for families that depend heavily on one earner. If that one breadwinner dies, it leaves their surviving family without enough income to cover their living expenses.
The same principle applies to long-term disability insurance. The breadwinner could suffer a health crisis which prevents them from working and earning money, even though they continue living. But the result is the same for the family: loss of income.
Review your family’s dependence on a single earner to survive before deciding whether to buy life insurance and/or long-term disability insurance.
Create an Estate Plan
Every adult needs an estate plan. And the greater your assets or number of dependents, the more urgently you need one.
Without a will or estate plan, people who die intestate leave their families with a tangled legal mess upon their death. Hardly the legacy most of us want to leave behind. In particular, minor children need the smoothest possible transition after losing their parents.
Most people don’t need to spend much on creating their estate plan. Start by creating a last will online through a reputable online legal services website. It costs little money but leaves your family in far better shape if you meet an untimely demise.
Those with higher net worths should speak with an estate planning attorney, as their estates tend to be more complex. But middle-class Americans can start with online legal services for their will.
Create an Asset Protection Plan
Only people with higher net worths need to spend much time or money on asset protection. But anyone can be sued at any time, for anything. As a result, people with more to lose need to think about ways to protect themselves.
Generally speaking, you should start small with asset protection and only layer on more complexity as you grow from “successful” to “wealthy.” Speak with an asset protection attorney if your net worth has crossed into seven digits. They can walk you through options such as irrevocable trusts, foreign legal entities, and other options for both anonymity and protection.
Get a second opinion before spending tens of thousands on outlandish legal maneuvers. But for wealthy Americans, a little foresight and prevention today can save millions tomorrow.
Pay Down Your Secured Debts
Loans secured with collateral, such as a car loan or home mortgage, come with lower interest rates than unsecured loans, making them a lower priority to pay off than your higher-interest unsecured loans.
Still, paying off these secured debts offers a guaranteed return on investment: avoiding those interest payments in the future. If you don’t know what else to do with your tax refund and want a low-risk way to “invest” it, pay down your auto loan.
Home mortgages come with even lower interest rates than auto loans. That makes them even a lower priority for payoff.
People in or nearing retirement have a lower risk tolerance than younger adults. Rather than chasing a 7-10% return by investing in the stock market, they may happily accept a guaranteed 3-5% return by paying off their mortgage early. Lower living expenses mean less passive income needed to retire, which means paying off your mortgage early can help you retire.
Move for Lower Cost of Living
The median home price in San Francisco is $1,425,867, according to Zillow. In Cleveland, the median home costs less than 1/17th of that: $84,157.
However, it says nothing of taxes like income, property, or sales taxes. Or the cost of local services and goods.
For that matter, no one says you have to stay in the US. My family and I live overseas and enjoy far lower living expenses than we had in the States. A full-time nanny costs around $500 per month, and an upscale restaurant dinner for two costs us a total of around $25. We live a comfortable lifestyle entirely on my wife’s salary as an educator, allowing us to save and invest all of our income.
Yes, moving costs money upfront. But by covering that initial expense with your tax refund, you can reap the benefits of lower living expenses for decades to come.
And that means not only more bang for your buck, but also the option to save and invest more money and build wealth far faster.