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Why Using Your Tax Return to Save for Retirement Is a Really Good Idea

Roughly 7% of Americans plan to use this year's tax return to save for retirement, according to GoBankingRates. The figure rises to 10% for older millennials between 35 and 44, and for soon-to-be retirees, aged 55 to 64. Is this a good way to put the lump sum you get back from the Internal Revenue Service (IRS) to work?

Compound returns can power retirement funds

Kudos to these respondents. Putting windfall profits -- sums of money from one-time events -- into a retirement plan is a time-tested way of growing your retirement nest egg.

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Funding retirement savings is a valuable way to use the money because it lets your assets grow by compounding, a powerful and invisible market force that grows your money exponentially.

The average tax return expected this year is more than $3,000. Let's say you put $2,500 of that amount into a retirement savings account. In 30 years, assuming an average stock market return of 7% per year, that $2,500 will have grown to $19,000. If you save part of your tax return every year, you'll have a retirement nest egg that can let you live comfortably for quite a while.

Investing your tax return is a good way to boost an already healthy retirement plan for retirement savers who use an Individual Retirement Account (IRA) or a workplace plan like a 401(k).

It's an even better move for the estimated 42% of Americans who don't have anything saved for retirement. If you find yourself living paycheck to paycheck, with your monthly income primarily paying for basic expenses and bills, you may be having a tough time carving out anything for retirement savings.

But failing to save now, even when money is tight, will hurt you later on, because Social Security is only designed to cover 40% of a worker's pre-retirement income. Meanwhile, retirees are expected to need 80% of their preretirement amount to maintain their lifestyle, so you'll have a shortfall between your expenses and your income in retirement if you don't have savings.

If you're unable to save monthly for retirement, saving a big slice of your tax refund in a tax-advantaged retirement vehicle is a great way to start a nest egg.

Potential for tax savings

While harnessing compound growth is the primary motivation for saving for retirement, there's another compelling reason beyond big returns. Both 401(k)s and IRAs are tax-advantaged plans, so you save on taxes, and your retirement funds grow tax free.

Let's look at how that works for each retirement savings vehicle. For 2019, you can contribute $19,000 to a 401(k) ($25,000 if you're 50 or older) and $6,000 to an IRA ($7,000 if you're 50 or older).

In a 401(k), your employer contributes money from your paycheck before income tax is levied, making it pre-tax income. In the year you contribute it, you won't be taxed at all on that part of your income, which could even send you into a lower tax bracket today. Contributions to a traditional IRA are tax deductible in the year of contribution, so these contributions also lower your taxable income for the year, which will certainly save you in taxes and could also move you into a lower bracket. A person who makes $65,000 per year and contributes $6,000 to a traditional IRA will only pay their tax rate on a base of $59,000.

In both 401(k) plans and traditional IRAs, your money grows tax free. Qualified withdrawals will be taxed at your ordinary income rate when you take them in retirement. You become eligible to withdraw money from these accounts as early as age 59 1/2, but required minimum distributions (RMDs) that force you to take out part of the money each year don't kick in until you reach age 70 1/2.

A Roth IRA works differently from a traditional IRA. Contributions to a Roth IRA are not tax deductible in the year you make them; they are made with money that was taxed when you earned it. But these contributions grow tax free, just as 401(k)s and traditional IRAs do. There are never RMDs for Roth IRAs, so you can keep it in the account to grow as long as you like, well into your later years. Plus, the tax advantage for Roth IRAs is that funds are not taxed at all when you withdraw them in retirement, which can be a huge benefit for people with limited retirement savings.

The chance to save on taxes is an additional incentive to use money from your tax refund for retirement savings. Plus, yearly contributions to IRAs can take place until April 15 of the following calendar year, so if you still want to deduct a traditional IRA contribution from your 2018 taxes, you can do so until April 15, 2019.

Know what to expect from your tax refund this year

A caveat may be in order about the size of this year's tax return. In February, many people were seeing less than they expected in refunds from the IRS. The reason is simple. The Tax Cuts and Jobs Act lowered taxes for many Americans and because the bill went into effect in early 2018, many employers adjusted their withholding early last year.

As a result, you may have been seeing more in your paycheck throughout the year because less was being withheld. But that boost is offset by the fact that you may get a smaller tax return -- or you may actually owe money to the IRS even if you haven't in the past.

In early March, though, the IRS began saying that tax returns rose modestly, by slightly more than 1%. It all depends on your tax bracket and your withholding, but it's a good idea to complete your tax return as early as possible so you know what your refund will look like. Then, you can decide the best use for your refund, if you get one.

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