What Are You Doing With Your Tax Refund?
April 4, 2016 | Your Finances
Many of us are likely to get a tax refund that will be a welcome windfall. What are you planning to do with yours? According to a survey by H&R Block in 2015, half of Americans who get a refund will save a portion of the money. That’s a smart decision that can add up to a lot of money over time.
The key is compounding, which has been called the “eighth greatest wonder of the world.” Compounding is the snowball effect that happens when your earnings generate even more earnings as the years roll on. Interest is calculated on both the initial principal (the money you save) and on interest you have already earned. Over time your account balance can grow larger than the amount of money you put into it.
What if You Invest a Portion of Your Refund Each Year?
Let’s say you decide to set aside $1,000 from your tax refund every year and invest it in an account assuming a 7 percent rate of return compounded annually. What if you did that for several years or even your entire working life? Over time, it would add up to a lot of money.
If you started saving $1,000 from your tax refund at 25 and did so every year until you were 65, you would have invested $40,000. But because of the compound interest you would earn over that long time horizon, you would have $213,609 when you are 65.
And starting early makes a big difference. Let’s say you wait until you’re 35. You would invest $30,000, but you would have only $101,073 at 65. If you wait until you’re 45, the amount you’d have at 65 drops to $43,865 on a $20,000 investment.1
When your tax refund check comes this year, what do you plan to do with it? By investing some of it for the long term, you can make a big difference later in your life.
To get the full benefit of compounding, look for opportunities to save more. Take advantage of opportunities to save when it doesn’t hurt. Your tax refund is a great opportunity to do that. There are other opportunities as well. Set aside a portion of your bonus or annual raise or some of the proceeds from the sale of a property or money you inherit. When you pay off debt, put back a portion of the money that your creditor no longer gets.
That’s the power of compounding. Even a small investment can result in a substantial build-up of wealth, and the sooner you begin, the greater the reward.
1These scenarios are for illustration purposes only. All investments carry risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth.