How to Invest Your Tax Refund: IRA, 401(k), and Smart Financial Strategies for 2025
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In 2014, the average tax refund was about $2,700. If you received that much this year, what would you do with it?
You can probably think of a lot of things you might do with $2,700. You might decide to splurge and buy some big-ticket item you’ve been eyeing. Or you could use the money to pay down some bills, which might be a good idea, especially if it helps improve your cash flow.
As an alternative, though, you might want to consider investing the money.
You might not think $2,700 would make that big a difference to your investment portfolio. But if you invested that $2,700 in a tax-advantaged account, such as an IRA, and you left the money alone, what might you earn?
After 30 years, your $2,700 would have grown to more than $20,500, assuming no further contributions and a hypothetical 7% annual return. That’s not a fortune, of course, but it would help boost your retirement savings somewhat, and since it originated from a tax refund, it was accumulated pretty effortlessly from your point of view.
Now, suppose you put in the same amount, $2,700, into your IRA each year for 30 years. Again, assuming the same hypothetical 7% annual return, your money would have grown to more than $272,000. And that amount can indeed make a rather big difference in your retirement lifestyle.
Tax Considerations: Traditional IRA vs. Roth IRA
Keep in mind that you’d eventually have to pay taxes on that $272,000 if you had been investing in a traditional IRA, which is tax-deferred but not tax-free. It is possible, however, that if you start taking withdrawals when you retire, you’ll be in a lower tax bracket.
Recent law changes have also given traditional IRA owners a bit more flexibility: You can now delay Required Minimum Distributions (RMDs) until age 73 (per the IRS), giving your money more time to grow tax-deferred.
If you meet the income guidelines for contributing to a Roth IRA, though, you could avoid the tax issue altogether on your $272,000. Roth IRA earnings grow tax-free, provided you don’t start withdrawals until you’re 59½ and you’ve had your account for at least five years.
For 2025, your Modified Adjusted Gross Income (MAGI) needs to be under about $150,000 (for single filers) to make the full Roth IRA contribution of $7,000 (or $8,000 if you’re 50 or older).
What If You’re Already Maxing Out Your IRA?
Thus far, we’ve only talked about putting your tax refund to work in your IRA, which, as we’ve seen, can be a very good idea. But suppose you’ve already developed the excellent habit of “maxing out” on your IRA each year by contributing a set amount each month.
For 2025, you can contribute up to $7,000 per year to your IRA (or $8,000 if you’re 50 or older). So you could fully fund an IRA by putting in about $583 per month (or $667 per month if you’re 50 or above). These amounts are not unreasonable, especially as you move deeper into your career and your salary increases.
If you do reach these limits, what could you do with your tax refund?
Diversification: A Smart Use for Your Refund
You can start by looking closely at your overall portfolio to see if any gaps exist. Could you, for example, use your tax refund to further diversify your holdings?
While diversification can’t guarantee profits or prevent losses, it can reduce the impact of volatility on your portfolio. And the less you feel the effects of market volatility, the more likely you are to stick with your long-term strategy rather than overreacting to short-term price drops.
Lump-Sum Investing vs. Dollar-Cost Averaging: What’s Better for Your Refund?
Should you invest your entire refund at once or spread it out over time?
Lump-Sum Investing
Historically, lump-sum investing tends to outperform dollar-cost averaging because your money spends more time in the market. For a $2,700 tax refund, if you’re confident in your risk tolerance and the market’s long-term trajectory, a lump-sum investment might be better.
Dollar-Cost Averaging (DCA)
This approach spreads your investment over time to reduce the impact of market volatility and psychological barriers. It can be helpful if you’re nervous about market timing or want to ease into investing.
Inflation: The Silent Eroder of Wealth
While a 7% annual return sounds attractive, it’s crucial to factor in inflation, the silent eroder of purchasing power. Over 30 years, an average inflation rate of 3% could reduce the purchasing power of your $272,000 investment to around $112,000 in today’s dollars.
This is why it’s essential to not just invest, but to invest for growth, diversify wisely, and consider inflation-resistant assets like real estate, stocks, and commodities.
Behavioral Finance: Why Don’t More People Invest Their Refunds?
Despite the math, many people struggle to invest their tax refunds. Behavioral finance concepts help explain why:
- Loss Aversion: We fear losses more than we value gains.
- Present Bias: We prioritize short-term gratification over long-term rewards.
- Procrastination: Delaying action can erode potential returns.
- Lifestyle Creep: Refunds often get spent on “wants” rather than “needs.”
Understanding these tendencies can help you make smarter financial choices.
Special Considerations for Divorced Individuals
Financial planning is especially important after major life changes like divorce. Research shows that women, on average, experience a 30% drop in wealth after divorce. Here are strategies for using your tax refund post-divorce:
- Build or replenish an emergency fund.
- Start or increase contributions to a retirement account as a solo earner.
- Pay down joint debts or legal fees.
- Create or update an estate plan.
- Contribute to college savings for children.
While the previously referenced Divorce Digest guide may no longer be readily available, there are many up-to-date resources and professionals who can help divorced individuals create a solid financial plan. By staying informed on current financial rules and making the most of opportunities like your refund, you’ll be better positioned to achieve long-term stability and peace of mind in 2025 and beyond.
The Bigger Picture: Tax Refunds and Financial Freedom
Your tax refund isn’t just a “bonus”; it’s an opportunity to make real progress toward financial independence. Whether you invest, save, or pay down debt, intentionality is key.
Use this moment to:
- Set SMART financial goals (Specific, Measurable, Achievable, Relevant, Time-bound).
- Review your financial plan regularly.
- Seek guidance from a qualified financial advisor.
FAQs: Your Tax Refund, Your Future
What is a Required Minimum Distribution (RMD)?
An RMD is the minimum amount you must withdraw annually from a traditional IRA or 401(k) starting at age 73. Roth IRAs do not have RMDs.
How can I adjust my investment strategy for inflation?
Consider diversifying into stocks, real estate, or inflation-protected securities (TIPS) to help preserve your purchasing power.
Can I invest my tax refund in a real estate property?
Absolutely! While $2,700 may not buy property outright, it can be a down payment on a REIT (Real Estate Investment Trust) or fractional real estate investing platforms.
What if I can’t max out my IRA each year?
That’s okay! Start where you can. Even small, consistent contributions grow over time.
Is it better to invest or pay off debt with my tax refund?
It depends on your interest rates. If your debt has a higher interest rate than your expected investment return (usually >6-7%), pay off the debt first.
Can I use my tax refund for my child’s college fund?
Yes! Consider contributing to a 529 plan, which offers tax-advantaged growth for education expenses.
Ready to Make Your Tax Refund Work for You?
Don’t let your tax refund slip through your fingers. Invest it, save it, or use it wisely to build a stronger financial future.
For more information, please contact:
Janelle Percy, AAMS® – Financial Advisor, Edward Jones Investments
25129 The Old Road #103, Stevenson Ranch, CA 91381
