Strategies for Investing My Tax Return Refund (and should I be adjusting my withholdings moving forward?)

Last year, the IRS issued 107,880,000 tax refunds totaling $337.595 billion. That's a decline of about 15% from 2022, but the average refund went up by 12.8% to $3,129. 

For most Americans, that's a nice chunk of change. What do people do with that money? According to research from GOBankingRates, about 25% of people plan to save it, 21.16% plan to pay bills with it, and 19.66% say they'll pay off debt. 

A $3k bonus in April might not seem like a bad idea, but it also might make you wonder if that $3k would have been better "spent" elsewhere. - but we'll talk more about adjusting withholdings later.

First, what should you do if you expect to receive a refund — or have already gotten one — in 2023?

What Is a Tax Refund?

It’s no surprise; a  tax refund is the amount of money the government refunds to a taxpayer after filing their income tax return. This refund occurs when the amount of taxes paid during the year is more than the amount owed. 

Taxpayers may receive their refund through direct deposit, a check, or an online transfer. They may also be able to use the refund to pay taxes they still owe from a previous year or apply it to the current year’s taxes. For some, a tax refund can act as a forced savings plan and provide taxpayers with extra money to pay off debts, save for retirement, or invest in the stock market. What strategy should you employ?

Best Strategies for Investing a Tax Refund 

If you owe student loans, auto loans, credit cards, or personal lines of credit, consider putting the extra money toward paying off these debts quicker. If you haven't already saved 3-6 months of expenses in an easy-to-access account, then you will likely want to park your refund there.

If you already have a fully funded emergency savings account and have paid off your non-mortgage debt, then investing your return may be a good strategy. What is the best investment if you decide to invest? 

Consider Investing in Yourself 

Not all investments are about stocks, bonds, or real estate. Often, one of the best investments you can make is in your family, health, or even your own career growth. Have you wanted to create more time for the family to get together, spend a weekend away, or have a family night out at the movies or bowling alley? Your tax refund may be the extra motivation to make that happen. If you've been wanting to take a class, earn a certificate, attend a boot camp or retreat, or hire a career coach, your tax refund may cover that cost. Suppose your investment in yourself leads to a healthier family, a promotion, or a new job; the corresponding return or bump in salary might be more valuable than what you would get elsewhere.

Set Realistic Goals

It’s important to set realistic goals when investing. It’s easy to get caught up in making big returns, but this could lead to unrealistic expectations or foolish mistakes. Consider aiming for steady growth instead of expecting too much too soon. To give you an idea of what a realistic expectation might be, consider this: From 1972 —2021, the S&P 500 returned 11.17% annually. Adjusted for inflation, that becomes 7.0%.

Remember Your IRA, HSA, and 529

Individual Retirement Accounts (IRAs)

In 2023, Americans under age 50, can contribute $6,500 to a Roth or a traditional IRA. That amount increases by $1,000 for people over 50. it's important to discuss this with your wealth management professional before investing your return in a retirement account; there are income restrictions on who can and can not contribute.

Health Savings Accounts

If you’re not already making the maximum contribution into your Health Savings Account and you expect to spend more on healthcare this year than last, consider padding your HSA with your tax refund. Better yet, increase your contribution and invest that money for future healthcare expenses. In 2023, the IRS limits HSA contributions to $3,850 for individual coverage and $7,750 for family coverage. You must also have a qualifying healthcare plan to be able to contribute.

Educational Savings Account

If you are contributing to your child's or grandchild’s 529 or other college savings plan, you might invest your refund there. The IRS has established annual contribution limits for educational savings accounts, so make sure your refund is at most what's allowable.

What Not to Invest In

A cardinal rule of investing is, don’t invest in something you don't understand. If you need help understanding it, seek the counsel of a trusted advisor or mentor.  

Before you invest, consider your family's goals and your comfort levels with risk. Then consider the risk of an investment before making it. Putting your refund under the mattress or in a "safe" investment, such as a CD or savings account, may not provide the growth you are hoping for. Investing in riskier assets, such as cryptocurrency, individual stocks, or just stocks in general, may not be the correct answer for you either. 

Instead, investing your tax refund in a well-thought-out strategy that helps you accomplish your overall goals might be. 

Should I Adjust My Tax Withholdings?

Getting a big tax refund feels great in the spring when it drops into your bank account, but it may not be the best way to handle your taxes or your paycheck. Often, the best approach is to match your withholdings to your tax bill as closely as possible.

If you regularly receive a large tax refund, consider adjusting your withholdings. This refers to the amount of taxes taken out of your paychecks throughout the year. By altering your withholdings, you can reduce your chances of overpaying taxes and getting a large refund each year. Instead, you keep your money as you earn it.

Before making any changes, make sure to speak with a financial planner or tax professional for advice. They can help you determine if this approach is right for you. 

Considerations for Adjusting Withholdings

First, consider your financial goals and lifestyle. If you want to save a certain amount each month and would prefer not to get a large refund at tax time, then reducing your withholdings could be beneficial. Conversely, if you like getting a refund each year and the thought of owing money at tax time makes you cringe, then leaving or increasing your withholding might be right for you. 

If you’re used to getting a refund, consider what you would or could do with this money instead. 

Additionally, it’s important to understand the impact of adjusting your withholdings on your overall tax liability. Depending on how much you adjust your withholdings, you may find yourself owing money at the end of the year or getting a larger refund than you are expecting. Reducing your withholding by too much could result in a penalty. Increasing it too much could affect your day-to-day cash flow or ability to fund your goals 

Benefits of Adjusting Withholdings

Adjusting your withholdings can help you balance your cash flow and achieve financial stability throughout the year. It can also provide an opportunity to increase your savings and investments by using the extra money from your paycheck. This can be especially helpful if you’re trying to build an emergency fund, avoid or pay down debt, or make a major purchase.

By reducing your withholdings, by the ideal amount, you simultaneously increase your regular paycheck. You are taking your pay when you earn it instead of later. You're effectively paying yourself instead of loaning it to the government. 

Impact of Adjusting Withholdings

Adjusting your tax withholdings can have an impact on your financial life. It's important to think carefully before making any changes to the amount of taxes you are having withheld from your paycheck. 

One of the primary impacts of adjusting your withholdings is that it can change the amount of money you receive as a refund or the amount you owe when you file your taxes each year. If you’re having too much withheld, you’ll get a larger refund but you’ll essentially be loaning the government money interest-free. Alternatively, if you’re having too little withheld, you may owe more in taxes and a penalty and interest when filing your return. 

It’s important to understand how adjusting your withholdings may affect your financial situation before making any changes. Doing some research on your personal financial goals and consulting a tax professional can help you make an informed decision about how much tax you should have withheld from each paycheck.

Lastly, it’s important to remember that investing your tax refund, or any funds, can be risky, and if you don’t have an emergency fund or cash savings account set up, it may be more prudent to use your tax refund to build up your savings or pay off your debts. This will give you more flexibility in case of any unanticipated expenses that may arise.

If you have questions about how to invest or you'd like to get started with wealth management, give us a call. The team at Cooke Wealth Management would love to sit down and talk with you.