How to invest your 2021 tax return

Wondering what to do with your 2021 tax return, or how to invest it? A tax return can provide you with a hefty lump sum of funds you’ll want to take advantage of. For instance, you could use it to kick start your investment accounts and grow your money for the future. Here are some of the best ways to start investing and grow your money. 

Please note that MoneyLion does not provide tax advice. Please consult a tax and/or legal advisor for guidance regarding your individual situation. 

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Why does investing matter?

Outside of having an emergency fund, keeping your money in a savings account probably isn’t enough to secure your financial future. While savings accounts have the benefit of being FDIC-insured up to $250,000, they ultimately earn too little interest to keep up with inflation over time. 

Top-earning savings accounts today generally earn only around 0.70% APY, while the inflation rate in the U.S. averaged 3.25% from 1914 to 2021. Investment accounts come with greater risk than savings accounts, but they’re also a much more powerful tool to help you grow your money for the future. 

What about the risk of investing?

When it comes to investments, there is always some degree of risk involved. For starters, investment accounts are not FDIC insured, meaning your funds aren’t backed by the government. Investments are also subject to market volatility and occasional swings in value. 

While it’s impossible to eliminate investment risk entirely, you do have some control. Knowing how to invest and the right ways to manage risk can help. It’s important to diversify your investments and set the right risk tolerance for your situation.

How to grow your money with compounding interest

Compounding interest is one of the best ways to grow your money. Compounding interest is when interest earned gets added to the principal amount invested. From there, the interest rate applies to the new, larger principal, creating a cycle where your original principal grows faster and faster. It essentially boils down to earning interest on interest, as well as the original principal.

Best ways to invest your 2021 tax return

Your 2021 tax return can be a great source of funds to kick-off your investing journey. But it’s important to understand first how to invest and grow your money. Take a look at some of the different types of investment accounts and the best ways to grow your money. 

Emergency fund

Before investing your 2021 tax return, consider if you need to boost your emergency fund. This will help you keep cash on hand for when emergencies happen.

If you don’t already have an emergency fund, creating one should be your first priority. Ideally, you want to set aside at least 3 to 6 months of living expenses in an emergency fund. Consider keeping your emergency fund in one of these types of accounts:

• High yield savings account: A high yield savings account offers more interest than a traditional savings account. Although it’s still much lower than what an investment account might offer over the long run, it’s a good option for an emergency fund because it’s FDIC insured, which means your money is protected. 
• Money market account: A money market account is issued by banks and credit unions and, like savings accounts, the majority of them are FDIC insured. However, money market accounts offer current market interest rates, which can help you earn more than a traditional savings account. 

Retirement account

Saving money for retirement is one of the most important financial moves you can make. There are many different types of retirement accounts you can contribute to depending on your situation. Your employer may even offer a retirement plan that includes additional benefits or matched contributions. 

• Roth IRA: A Roth IRA is an individual retirement account where you pay income taxes on the money deposited in your account, but then all future withdrawals are tax free.
• Simple IRA: A Simple IRA works similarly to a Roth IRA, except that it’s provided by an employer or small business owner.
• SEP IRA: A Simplified Employee Pension (SEP IRA) is another type of IRA that’s adopted by business owners to provide retirement benefits for themselves and employees.
• 401(k): A 401(k) is an employer-provided retirement account where you can deposit funds before taxes and pay income taxes only when you make future withdrawals.
• Solo 401(k): A solo 401(k) is typically for business owners who don’t have full-time employees, but still want a retirement account with benefits. 

Diversified investment account

This type of account is sometimes referred to as a taxable brokerage account or a non-retirement investing account. There are no limits to how much you contribute, plus you have the ability to create a diversified portfolio made of stocks, bonds, and ETFs.

Education account

An education savings account can be a great option to help pay for education expenses for you or your children. You could make contributions to a 529 savings plan or a Coverdell Education Savings Account (ESA). These accounts are not tax-deductible, but qualified distributions are tax-free. 

Investment account for kids

If you have children under 18 who come into money or earn money on their own, you can open investment accounts for them that will be ready when they come of age. 

• Custodial brokerage account: This type of investment account is in a child’s name but managed by an adult until they turn 18. 
• Custodial IRA: A type of IRA managed by an adult until the child comes of age. Custodial IRAs can be used to fund college tuition or even a first home. 

Should I hold off on investing my 2021 tax return if I have debt?

Debt, especially high-interest debt like payday loans or credit cards, can really cut into your finances. It may make more sense to put your 2021 tax return toward paying off your debt. Even then, it’s also a good idea — if you can — to set some funds aside in an emergency fund.