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How Should We Invest Our Tax Refund?

For as long as I can remember now, our yearly tax return is usually over $5,000. I am not going to debate whether it is a good idea to give the government a free $5K loan each year. I will save that argument for another date.

My wife and I have always used these returns to help fund our kids future education through 529 plans. While we are not wasting this money on crap we don’t need, there is some debate on if a 529 plan is the best option.

I love my kids and want to help them out anyway we can. I also want them to know what it is like to work for everything they have. To teach them about earning money on their own and not rely on others for their financial security.

That got me thinking recently about what to do with our tax refund this year (above $5K again). Should we continue to invest in our kids college funds? Or is there a better option to invest this money?

Investing in Dividend Stocks

One investment alternative that I always look to for extra windfalls of money are dividend stocks. For the most part, investing in dividend stocks will provide a sustainable source of future income. While I certainly could continue to put this money into my kids 529 plans, investing in dividend stocks could be a nice alternative.

If I were to take $5,000 this year and invest it in the market, I could increase my 12 month forward dividend income by approximately $218.50!

This of course is just an estimate based on my current yield on cost of 4.37%, which tends to stay fairly constant throughout the year. New stock purchases throughout the year tend to balance out any dividend reimbursements and/or annual dividend increases made.

Tax Refund = $5,000
Yield on Cost = 4.37%

$5,000 X 4.37% = $218.50

The calculation above is an educated guess of what I could potentially be earning from investing in the market using my 8 step stock selection process. While no dividends are guaranteed, I think this is a good representation of a possible return on investment. Of course, this doesn’t take into consideration any capital gains or losses as a result of fluctuating share prices.

Compounding Interest

Getting back an extra $218.50 sure would be a welcome addition to my dividend income stream!

However, why should I just stop there? What if my wife and I decided to continue to invest $5K from our tax return over the next 5 years consistently? What would happen if we continued to earn dividend income that was reinvested into more stocks?

The power of compounding interest is such a huge tool. Let’s take a look at a scenario where we invest $5,000 for 5 years straight. Let’s assume that we will continue to earn around 4.37% yield on cost and that we will see at least a 6% dividend growth rate each year.

Note – I use a filter of 10 year dividend growth rate greater than 6% when selecting stocks.

Year #1

In year #1, I would earn $218.50 – which we already discussed above. Nothing really changes here when it comes to the dividend income earned.

1st Tax Refund Investment = $5,000
Average Yield on Cost = 4.37%

Dividend Income Year #1 = $218.50

Year #2

The second year gets a little more interesting for sure. We have our original $5,000 investment from year one plus we are going to reinvest our $218.50 in dividends. Our original principal is then $5,218.50 plus another $5,000 tax refund investment for a total of $10,218.50 working hard for us.

We are also going to assume that our yield on cost remains stable at 4.37%. Because I am investing new money each year, I am going to assume my YOC remains stable. The return on new money will basically offset any dividend growth (6% or more) and reinvested dividends.

By the end of the second year, we will have potentially earned $446.55 in dividends – more than double last year! Say What???

Original Principle + Reinvested Dividends = $5,218.50
2nd Tax Refund Investment = $5,000
Average Yield on Cost = 4.37%

Dividend Income Year #2 = $446.55

Year #3

During year three we would continue to see growth, although not as big a percentage jump as between years one and two. This time around we would see just over 50% increase in dividend income – which is still awesome!

Our original principal balance totaled from years one and two ($10,665.05) plus the new tax refund money ($5,000) gives us over $15,000 in the market working for us!

Original Principle + Reinvested Dividends = $10,665.05
3rd Tax Refund Investment = $5,000
Average Yield on Cost = 4.37%

Dividend Income Year #3 = $684.56

Year #4

As we move into year four, the compound machine is rock-in and rolling! With over $21,000 invested in the stock market, we almost hit $1,000 in dividend income for the year but not quite. During year four, we would earn approximately $932.98 in dividends!

Original Principle + Reinvested Dividends = $16,349.61
4th Tax Refund Investment = $5,000
Average Yield on Cost = 4.37%

Dividend Income Year #4 = $932.98

That is a 36% increase in annual dividend income from the previous year.

Year #5

As we enter into year five, our dividend income stream created by investing our annual tax returns is in full gear. We now have over $27,000 working for us in the market from tax return money and reinvested dividends.

We finally break $1,000 in annual dividend income in the fifth year with $1,192.25 coming back to us in cash.

Original Principle + Reinvested Dividends = $22,282.59
5th Tax Refund Investment = $5,000
Average Yield on Cost = 4.37%

Dividend Income Year #5 = $1,192.25

Not Done Yet!

Did you think I could just stop at 5 years. Since my oldest son won’t even be in college in 5 years, why not extend it out to 7. That is when he would start college.

By year number seven, we have almost $40,000 working in the market for us. This is when things get really fun. During year seven, we would earn $1,745.28 in dividend income! That is a 46% increase in just 2 years.

Dividend Income Year #7 = $1,745.28

Since I like round numbers, lets see what happens at year ten. By that time, our second child will be getting ready to start college. The good thing is that our dividend income after year 10 would be $2,668.79!

Dividend Income Year #10 = $2,668.79

What if we held out to twenty years? At that point, we would have over $150,000 working hard for us in the stock market earning dividends.

Assuming we continued to invest $5,000 every year in tax return money for 20 years earning 4.37%, we would earn $6,762.07 in annual dividends!

Dividend Income Year #20 = $6,762.07

Final Thoughts

I enjoy playing around with these types of numbers. So what is a better way to invest? Use our tax return money to invest in our kids 529 plans? Or invest in blue chip stocks and build a dividend income producing machine?

Either option certainly has its benefits.

What do you suggest we do with our tax return money? Continue to invest in our kids college education? Or invest in the income producing machine known as dividend stocks?

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