As the Federal Income Tax deadline fast approaches, you might already be dreaming of ways to spend that check. What you should do with your tax refund depends on your individual financial goals and situation.
If you decide to grow your refund by investing it, there are many options available including stocks, bonds, mutual funds, interest-earning savings accounts and certificates of deposit (CDs). The choices can be overwhelming, but ultimately you want to know how much return you will receive for your deposit before picking an investment.
Here’s a simple, five-step method you can use to help decide how to best invest your tax return.
Step 1: Pick Different Investment Options to Compare
Whether you are considering an interest-earning savings account, a CD or some other option, it’s important that you choose at least two to get a complete comparison. You want to understand all your options.
Step 2: Decide How Much to Invest
Consider if you want to only invest just your estimated tax refund or put in additional cash. Of course, if you have the means, you might want to consider investing additional money to get more back in the long run.
Whichever you choose, the total will be the principal amount for your investment.
Step 3: Calculate the Number of Periods
Now you need to determine the number of periods that interest will be paid.
If the interest is being paid yearly, then the number of periods will be the number of years for the investment. For example, for a five-year CD that pays annual interest, the number of periods will be five.
If the interest is being paid more than once a year, multiply the number of years by the number of times interest is paid per year. For example, for a five-year CD that pays interest twice per year, the number of periods will be 10.
Note that if you are considering a savings account, then your number of periods would be the length of time you plan to keep the money in that account without withdrawing or adding funds.
Step 4: Calculate the Value of Your Investment Options
It might seem intimidating, but you can actually calculate the future value of your investment options fairly easily by using an online financial calculator or Excel spreadsheet.
If You Plan to Use a Calculator
You can utilize any online finance calculator, and you just need to input the below fields:
– Number of periods
– Principal amount to be invested
– Interest rate per annum
The calculator will do the math for you.
If You Plan to Use Excel
Input the following fields into the formula “= FV(rate,nper,pmt,pv)”. Again, you just need to fill in the appropriate information.
– Interest rate per annum (rate)
– Number of periods (nper)
– Principal amount to be invested (PV)
Annuity payment or PMT, for both the online finance calculator and Excel spreadsheet, should be zero except in certain situations which will be noted later. And for reference, the FV is the future value and represents the principal amount you invested plus all interest repayments.
An Investment Example
Let’s say you are considering investing $5,000 into a five-year CD at 0.88 percent per annum.
If using an online finance calculator, you would add in this information.
— Five for the number of periods
— $5,000 for the principal amount to be invested
— 0.88 for the interest rate per annum
If you decided to use the Excel spreadsheet, on the other hand, you would put the information into the formula. The formula “= FV(rate,nper,pmt,pv)” would therefore be =FV(0.0088,5,0,-5000). The principal amount is a minus in Excel because you are investing that money and therefore would have $5,000 less to start.
PMT will remain zero unless you are adding more money to your investment each year.
For the example investment of $5,000 into a five-year CD at 0.88 percent per annum, the future value (regardless of whether you used the calculator or Excel) comes out to $5,223.91. Therefore, the total interest paid is $223.91 for that period.
Step 5: Compare the Value of Your Investment Options
When it comes to investing, it is important to understand your options before diving in head first. After calculating the amount of interest for different investment options of the same period, you can compare and decide how to best invest.
So before blowing your tax return on that tropical vacation or fancy pair of shoes, and before sticking it away in a savings account that won’t accrue anything, consider turning it into an investment instead. Let your tax refund really work for you.
Click here to read more about how to get over your fear of investing.