Spending your tax refund is appealing, but investing it for retirement is a simple way to catch up.
The average refund amount for the 2020 tax year is $2,967, comparable to $2,973 a year ago, according to the IRS. “With a tax refund potentially on the horizon for some, the knee-jerk reaction may be to splurge — especially after the tough year many have faced,” says Mike Loewengart, managing director of investment strategy at E-Trade Financial, an Arlington, Virginia-based brokerage company. “But investing the extra cash could be helpful for the future, and the power of compounding comes into play.” To put your tax refund to work, here are six mutual funds or exchange-traded funds to consider adding to your retirement portfolio.
SPDR S&P 500 ETF Trust (ticker: SPY)
Investors looking for built-in diversification and relatively low fees could consider an index fund such as the SPDR S&P 500 ETF Trust, Loewengart says. The S&P 500 ETF includes the top 500 stocks of large companies and provides diversification. Putting your $3,000 refund in a tax-advantaged retirement account can not only reduce your taxes for this year, but it can grow and multiply, says Greg McBride, chief financial analyst at Bankrate, a financial data company. Look for a low-cost stock market index fund or ETF. “Investing $3,000 now at an average annual return of 7% means it grows to more than $14,000 in 25 years,” he says. “That’s just one year’s tax refund. If you put away $3,000 every year for the next 25 years, you find yourself sitting on a nest egg of over $189,000.”
Vanguard Total Stock Market Index Fund ETF (VTI)
This fund tracks the performance of the CRSP U.S. Total Market Index, which represents 100% of the investable U.S. stock market. The expense ratio is low at 0.03%. The advantage of an ETF is that there is no minimum investment required, says Robert Johnson, a finance professor at Creighton University. Investing in broadly diversified stock market index funds or ETFs avoids the risk of how one stock performs, he says.
Vanguard Global Equity Fund (VHGEX)
One way to diversify a retirement portfolio is to add stocks of companies based in Europe or Asia. The Vanguard Global Equity Fund owns about 50% of its portfolio in U.S. equities and has an affordable expense ratio of 0.45%. The portfolio consists of more than 500 stocks from more than 30 countries. People need to make saving money and investing a priority, Johnson says. The most common mistake is that people often increase the amount of money they spend as their salaries increase. Saving your tax refund or bonuses can help you reach your retirement goals sooner.
Vanguard Russell 2000 Index Fund ETF (VTWO)
Another way for investors to diversify their portfolios is by adding ETFs of small-cap or mid-cap stocks. Investors often put a large amount of their money in the large-cap space in an S&P 500 ETF. Small-cap stocks outperformed both large caps and midcaps in 2020. The S&P 500 generated a 16.3% return, while the S&P MidCap 400 produced a 13.7% return. Meanwhile, the Russell 2000, a small-cap index, generated a 20% return in 2020. VTWO gives investors small-cap exposure while charging an expense ratio of 0.1%. “Ironically, the biggest mistake many investors make is taking too little risk,” Johnson says. “Many investors also simply concentrate their holdings in the large-cap space, but over time small-cap stocks produce larger returns.”
Vanguard Mid-Cap Index Fund ETF (VO)
The Vanguard Mid-Cap ETF provides investors with broad exposure to mid-cap stocks and helps them avoid the volatility and risk of choosing a handful of individual stocks. The three-year annualized return is 14.65%, with a low expense ratio of 0.04%. Another advantage of dollar-cost averaging or adding money to an individual retirement account each month is that investors receive the benefit of the average of both good market years and down market years, says Stuart Michelson, a finance professor at Stetson University.
Fidelity Investment Grade Bond Fund (FBNDX)
The Fidelity Investment Grade Bond Fund owns both government and investment-grade corporate bonds. These types of bonds are less likely to default, making them a safer asset for investors — especially those seeking less risk and more income. The fund’s three-year return is 6.34%, and its five-year return is 5.65%. FBNDX’s expense ratio is affordable at 0.45%. Investing in bond funds and bond ETFs is advantageous over finding individual bonds, Michelson says. A portfolio of bonds provides more diversification and increases the return compared to choosing individual bonds, he says.
Six mutual funds and ETFs to buy with your tax refund:
— SPDR S&P 500 ETF Trust (SPY)
— Vanguard Total Stock Market Index Fund ETF (VTI)
— Vanguard Global Equity Fund (VHGEX)
— Vanguard Russell 2000 Index Fund ETF (VTWO)
— Vanguard Mid-Cap Index Fund ETF (VO)
— Fidelity Investment Grade Bond Fund (FBNDX)
