Tax refunds are on their way: What should you do with them?

A perspective from E*TRADE Securities1

02/22/19

Let’s face it: Tax season is a major pain. Organizing receipts and itemizing deductions can break the spirit of all but the most ardent paper pushers. Fortunately, there’s usually light at the end of the tunnel in the form of a tax refund. But deciding what to do with that refund can create its own set of challenges.

And this time around, there’s a new twist. Refunds aren’t coming back as fast or large as expected—following a major tax cut, no less. What gives?

Turns out, after passing the Tax Cuts and Jobs Act of 2017, Congress lowered withholding rates, although few people noticed at the time. While paychecks may have appeared fatter as a result of lower tax rates, that was partly an illusion, since less money was being withheld for taxes that would eventually need to be paid.

The result has been smaller refunds or, in some cases, an unexpected tax bill. In fact, through February 8, refunds are down nearly 9% from last year, with the average refund coming in at $1,949, according to the IRS. Last year, the average refund was $2,135.1 Caught by surprise and feeling the pinch, angry taxpayers are now giving lawmakers an earful.

IRS refund amounts year-to-date 2019

Source: Internal Revenue Service


What to do with a smaller refund?

Investors are now wondering just what to do with those diminished IRS checks. Beyond splurging, paying down credit cards, or taking a few bucks off of mortgage principal, there are numerous ways to invest tax refunds.

While putting money into individual stocks is one alternative, lofty equity valuations in some sectors reduce the number of shares investors can acquire, which can hamper efforts to diversify. In many cases, investors with relatively small refunds could find mutual funds or ETFs more attractive.

Mutual funds

Mutual funds allow investors to diversify their portfolios by providing access to a wide variety of companies without requiring the purchase of individual stocks. Rather than holding individual shares of a company, investors hold units of a given fund, which can be redeemed, but only at the end of the trading day. Both fixed income and equity mutual funds come in almost every shape and size, giving investors nearly limitless fund choices from which to choose.

Because they’re actively managed, mutual funds may have higher expenses than passive products, but they also have the potential to outperform the market. These days, many funds are offered with no sales loads or transaction fees (E*TRADE offers more than 4,440 such funds). Mutual buy-in levels vary—from less than $100 for many funds to many thousands of dollars for others.

ETFs

Exchange-traded funds (ETFs) are increasingly popular investment vehicles that combine attractive features of stocks and mutual funds. ETFs typically track an underlying index, much like a traditional index fund. But unlike mutual funds, ETFs trade on major exchanges, which means investors can buy and sell them during market hours while getting the gratification of securing shares as soon as the trade executes.

ETFs are also generally more transparent than mutual funds. Rather than waiting for a quarterly statement to find out what’s in a portfolio, investors in ETFs can typically see what each fund holds on a daily basis.

Perhaps most important to those smarting from lower tax refunds, ETFs (and passive strategies in general) often come with lower expense ratios and may not generate capital gains, which can lower future tax bills.

Effects of the government shutdown

Even if you do receive a refund this year, there’s yet another wrinkle. The recent government shutdown lasted a record 35 days, which has slowed the pace of processing tax returns.

Pace of IRS tax refunds, year-to-date 2019

Source: Internal Revenue Service


Investor takeaways

While there’s not much investors can do about the size of last year's refunds, there are some lessons to be learned:

•  A bigger paycheck doesn’t always mean more money in your pocket. As we’ve just witnessed, reduced tax withholding rates can cause paychecks to appear larger than they actually are.  

•  Refunds don’t always come back as expected, so think twice before budgeting for them.

•  Withholding decisions matter. The IRS recommends doing a “paycheck checkup” by using the withholding calculator on the IRS website. If in doubt, talk to a tax professional.

The tax man cometh—this past year, a little more stealthily than usual. But for those who’d rather invest than spend, the number of choices is larger than ever. If only we could say the same about those refunds.

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1.  Internal Revenue Service, “Filing Season Statistics for Week Ending February 8, 2019,” https://www.irs.gov/newsroom/filing-season-statistics-for-week-ending-february-8-2019