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7 Best Ways to Invest Your Tax Refund

So far this tax season, more than 64 million Americans have filed federal tax returns that entitle them to a refund, and the average refund is clocking in at a tidy $2,985. I'll leave it to others to explain why refunds are a sign you may have screwed up on your taxes. That might be useful feedback for next year, but it seems to me the more pressing issue is making the best investment move with the 2010 federal tax refund that's burning a hole in your bank account.

I am going to slide on past the obvious advice that if you have high-rate credit card debt, there's no smarter move than to get rid of it asap. But assuming you're not in that pickle, here are 7 smart uses for this year's tax refund:

1. Quadruple its value with a Roth IRA. Invest $2,985 today in a Roth IRA, let it marinate for 25 years at an assumed 6 percent annualized return, and your investment will be worth more than $13,000. You, of course, can choose any annualized rate of return, and yes, the long-term historical rate of return for stocks is about 10 percent. But that might be optimistic going forward; besides a well-diversified portfolio is going to have a large slug of bonds and maybe even some cash. So net net, I landed on 6 percent as a conservative return for a diversified portfolio. If I am wrong, you just end up with more. I'll take the heat for that.

2. Double its value for future college costs. Take the $2,985 and invest it in a low-cost 529 college savings plan, and 15 years later you could have more than $6,000. (I went with a more conservative 5 percent assumed rate here, because once your child turns the corner into sophomore year of high school and you'll soon be writing tuition checks, you're going to want to have most of your money in lower-risk bonds or cash.)

3. Pay down your mortgage. If you're in your 50s and have lost any quality sleep to retirement stress, think through how you might feel if you had the mortgage paid off sooner than later? If that just sounded pretty good, tune out all the noise about the investment opportunity cost of doing this, as well as the foregone tax break on the mortgage interest. Focus on what's important: peace of mind. And for many, paying off the mortgage is priceless.
4. Set it aside for a down payment. Whether you're a first timer or trade up home buyer, it looks likely that mortgages in the future will require larger down payments. Now might be a good time to start saving up more. Having more money to put toward car financing is also smart; it can help you qualify for the best lending terms, or if you've already got sparkling credit, a bigger down payment will reduce your overall borrowing costs.

5. Make things easy for your family by hiring a lawyer to pull together your estate planning documents. Come on, you know you need at least a will, and probably a revocable living trust as well. While we're at it, are you still dragging your feet on getting the durable power of attorney docs set up for both your financial and health care matters? For everyone's peace of mind, sitting down with a lawyer who specializes in estate planning seems like an excellent use of this year's tax refund. Depending on the complexity of your situation, it might cost a whole lot less than $3,000 to get everything set up.

6. Pay for some financial therapy. If during the past few years you've come to recognize that you have a tendency to bail when the market is low and only get itchy to invest after the market is way up, you've got a problem. Fear, anxiety, or whatever you want to call it is getting in the way of smart, long-term investing principles. It's not that you don't know what to do, just that it's hard to do it. Hiring a fee-only financial advisor to review your investment strategy and be an unemotional voice of reason can pay hefty dividends if it helps you stick more firmly to a long-term investment plan.

7. Buy a great experience. It may not necessarily have a direct financial payoff, but spending money to relax and enjoy yourself has tremendous value. The vacation you've been denying yourself could be a smart career move; a week or two of recharging the batteries can do wonders for your productivity. But even more important, as behavioral economist Dan Ariely explains, we derive more happiness from experiences than stuff. Using part of a refund to indulge in a series subscription to the local theater, or ball games, or a great pair of hiking boots that inspire you to hit the trail can be a rewarding and wise investment.

Photo courtesy Flickr user Tracy O

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