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Sunday, February 13, 2011

Taxes: Tips for investing your refund wisely

Tax refund
Investing tax refunds profitably offsets previous years' taxes
Wisely investing a tax refund means allocating the money from the refund in such a way as to  grow net worth,  improve fiscal credibility,  build financial security,  enhance quality of life, and  lower costly debt all at a low risk and maximum benefit.

This article will discuss ways to go about investing tax refunds wisely by breaking down the tax refund allocation decision(s) into three steps. These three steps are described in sections one through three and involve taking a personal financial snapshot, identifying options for investing, and optimizing refund allocation(s).

Taking the financial snapshot


The financial snapshot helps one gauge where one stands in terms of assets, debt, investments, credit record, budget situation, expenses and so forth. Without an accurate financial snapshot, properly allocating a tax refund investment may be haphazard. To take a financial snapshot, the answers to a few pointed questions can present one's financial situation quite well. A few such questions are listed below for the purpose of mapping a financial direction with which to proceed when investing a tax refund.

• How much is the tax refund?
• What amount of debt is included in your budget?
• At what stage of life are you?
• What are your financial goals?
• Is your budget well organized?
• Do you have an emergency account?
• What kind of Return on Investment vs risk do you prefer?

After answering these questions, one is ready to move to the next stage of investing a tax refund. The reason this is so is because one's financial picture is clearer and financial problems, goals and needs are more likely to have been identified by taking a financial snapshot. The next step is to identify investment options.

Identifying investment options


Identifying investment options helps one define what financial choices are available so one can later assess the quality, potential ROI, benefits and risk of those particular choices. This is an important step as demonstrates which financial vehicles are available for navigating through the financial map of one's personal finances. Often times there are many tax refund investment choices that can be made, however sometimes, simpler choices can be better. The following list presents some example tax refund investment choices that may be available.

• Pay off debt (Investment in to higher savings)
• Apply tax refund to following years tax (Increase future tax returns)
• Invest in high medium to high yield savings instruments
• Build credit by collateralizing loans
• Open or build an interest bearing emergency account

Pay off additional interest accumulating expenses

After one has identified available tax refund investment options one knows their financial situation through the financial snapshot, and what options are available to help improve or make that financial situation better. However, knowing which options to take, and why can help optimize one's tax refund investment decision for a potentially greater benefit had only steps 1 and 2 been taken.

Optimizing tax refund investment decisions


The purpose of optimizing a tax refund investment decision is to garner greater financial benefit as mentioned previously, but it also has the added effect of improving one's personal financial management skills and quality of life. To determine which tax refund investment has the most benefit its value must be measurable in some way. For example, investment benefits can be measured using the following metrics.

• Quantitative benefit ex-Increase to net worth, highest possible ROI
• Financial security ex-retirement savings, larger nest egg
• Improved credit score and/or rating
• Lower personal debt to asset ratio
• Improved leveraging and/or loan capitalization options

After acclimating with fiscal measurements one can then apply those measurement techniques to the tax refund investment options to assess which financial objective or group of objectives is most optimal in terms of allocating tax refund investment funds. For example, if money is used to pay off high interest debt, it has the potential affect of increasing savings through lower interest payment(s) on the debt. Over time, the lowered or eliminated debt is similar in returns to an investment in the sense that a return is achieved through the percentage increase in savings rather than return on investment. Either way more money is being retained and/or acquired.

Each tax refund investment option has different benefits and advantages whether it be tax deductible retirement savings, creation of a rainy day fund higher asset value etc. A method of optimizing makes use of one or all the various allocation/investment techniques for the greatest net benefit whether that benefit be financial, social, spiritual, physical, or psychological.

For example, utilizing all the previously listed metrics, and calibrating them all together for the combination of highest return, a tax refund may have been wisely invested. Moreover if one is able to pay off debt and/or refinance debt at a lower interest with a collateralized loan that is based on a tax refund invested in a high yield Australian Certificate of Deposit one is also improving credit worthiness by building credit history.

Thus, by optimizing, multiple financial goals can be achieved at once. To illustrate further, if debt at 14% APR is refinanced at 4% APR using a collateralized loan based on a certificate of deposit earning 5% annual yield, one earns10% interest savings on debt plus 5% on interest for a total of 15% return provided the total amount invested in the CD would have been used to pay off the debt at a rate of 14%.

Figuring out how to wisely invest a tax refund is not much different from any other investment decision. That is to say, if wise investments include monetary allocations that can yield return through savings and other positive metrics such as greater retirement security, lowered financial related stress etc., then tax refunds can be invested well and improve one's financial situation.

A good way to invest a tax refund would to do so in such a way as to optimize or maximize the total potential benefits of the monetary allocation i.e. why invest at 10% with high risk when you get 15% with low risk? This article has provided some possibilities on how to do wisely invest a tax refund by breaking down the investment decision process into 3 steps, the financial snapshot, tax refund investment options and tax refund investment decision optimization.

Image license: 401(K) 2012; CC BY-SA 2.0