Many taxpayers will be receiving a potentially large tax refund after over-withholding their 2017 taxes. While it's never a good idea to make an interest-free loan to the government, it is sometimes hard to avoid overpaying.
How to Get the Most Out of Your Tax Refund
If you find yourself with a sudden infusion of cash from your return, these are a few financially responsible ways to put that money to use.
Make a Charitable Donation
Using your refund to make a contribution to a cause is not only a simple way to give back, but doing so will also generate tax deductions that can help reduce your 2018 tax burden, said Paul DeLauro, City National Bank's manager of wealth planning. When making a tax-deductible donation, make sure it goes to a nonprofit entity that is approved by the IRS.
Invest Your Return
While many people are tempted to use their refunds on a splurge purchase, such as a luxury vacation or vehicle, don't forget about your longer-term goals.
"Allocate a portion of the refund to your overall investment portfolio," advised DeLauro.
Contribute to an IRA Account
Do you have any IRA accounts? If not, you may have a Roth IRA funding opportunity. The following concept works best if you have no money in IRA balances, so it's important to work closely on this with your financial planner and tax advisor.
IRAs and Roth IRAs permit contributions of up to $5,500 per year (with a $1,000 additional “catch-up" contribution if you are over 50). IRAs may be funded with pre-tax or after-tax contributions. Roth IRAs are only funded with after-tax contributions. Once you reach certain modified adjusted gross income thresholds, only after-tax contributions are permitted for IRAs and you are not permitted to contribute directly to a Roth IRA.
Ideally, you would want to contribute a portion of your refund to a Roth IRA. However, if you are unable to do so because your income is too high, you could fully fund your IRA with after-tax contributions and then convert those contributions to a Roth IRA. Over a 20-year period, you could fund more than $100,000 in a Roth IRA via this conversion technique, all with after-tax dollars growing and being distributed tax-free. You can fund your 2017 IRA or Roth IRA until April 15, 2018; if your refund is in excess of $5,500 (or $6,500 for those over 50) you could also contribute to your 2018 IRA.
Add to a College Fund
If you have children or grandchildren, some of your refund could be used to fund college education plans known as 529 plans. Those allow you to gift up to $14,000 per child (or $28,000 per child for married couples) per year. There are two types of 529 plans: a college savings plan and a pre-paid tuition plan.
Neither plan is tax-deductible. However, you will not have to pay tax on the income your investment earns annually. As long as you use the funds to pay for qualified higher education expenses — books, tuition, room and board — you will never pay income tax when you put the money to use.
Put Towards Your Irrevocable Life Insurance Trust
If you have an estate plan in place that includes an Irrevocable Life Insurance Trust (ILIT) — a life insurance policy used strategically to help pay for estate taxes and protect wealth — consider earmarking your refund for your annual premium gifting. This is also a good time to review whether the policy is performing as promised, whether the trustee is performing his or her duties according to the law, and whether you still need the policy.
Pay Down Debt
If you have debt — high-interest credit card debt, mortgages on your primary or secondary home, or home equity lines of credit — consider using some or all of the refund towards paying off that debt, DeLauro advised.
City National Bank, as a matter of policy, does not give tax, accounting, regulatory or legal advice. The effectiveness of the strategies presented in this document will depend on the unique characteristics of your situation and on a number of complex factors. Rules in the areas of law, tax, and accounting are subject to change and open to varying interpretations. The strategies presented in this document were not intended to be used, and cannot be used for the purpose of avoiding any tax penalties that may be imposed. The strategies were not written to support the promotion or marketing to another person of any transaction or matter addressed. Before implementation, you should consult with your other advisors on the tax, accounting and legal implications of the proposed strategies based on your particular circumstances.