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How to Turn Your Tax Refund into a Million Dollars

by Peter Renton on April 22, 2011

Now that tax season is behind us many of us will be wondering what to do with our tax refunds. According to the IRS the average tax refund this year is running right around $3,000. The smart thing to do would be to turn that refund into more than a million dollars.

How? Through the power of peer to peer lending and compound interest. It was Einstein who said that compound interest is one of the most powerful forces in the universe and peer to peer lending allows average investors to unleash that power in a dramatic way. To understand this power take a look at this chart.

Initial investment$3,000$3,000
Annual additions$5,000$5,000
Years to grow4040
Interest Rate7%10%
Value in 40 years$1,148,986$2,818,093

Let me explain the logic here. You start your investment this year with a $3,000 tax refund. Then you invest your tax refund every year for the next forty years, which I am assuming to be an average of $5,000 (this is likely conservative as inflation kicks up the average refund). I show a conservative number where you receive an annual return on your investment of 7% and one where the return is 10% (this latter number is closer to the return numbers both Prosper and Lending Club promote).

I chose 40 years because it really shows the power of compound interest, and for anyone under the age of 35 it provides a realistic time horizon. I am also assuming that you reinvest all principal and interest payments back into your p2p lending account on a monthly basis.

Now, I hear people saying that $1 million dollars will not be worth nearly as much in 40 years time. That is correct. If we assume 3% inflation over the next 40 years then $1 million will be worth around $296,000. But it is a mythical round number that we still use to measure wealth and I am using this number here to make a point.

Of course, there is one glaring omission in my calculations. Taxes. Yes, they will dramatically reduce your returns. But this doesn’t have to be the case, which is why I have omitted the impact of taxes in this table. The smart investor will invest in an IRA thereby eliminating the negative impact of taxes. Anyone who earns an income can open a Lending Club IRA (but you need a minimum balance of $5,000 to avoid the $100 annual fee). At this time, Prosper does not offer an IRA option.

Here is my main point. Most Americans get a tax refund every year. Many people consider this “free” money, so why not do something positive with it. If you invest your tax refund every year for 40 years into a high interest paying investment like p2p lending you will be end up with a large sum of money in 40 years. This sum will most likely be well over a million dollars.

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Dan B April 22, 2011 at 4:48 pm

I have no need whatsoever for $1.1 million when I’m 75. But I tell you what…………..I’ll put $3000 a year every year until I die into any investment you like starting right now……………& you cut me a check for $300k when I’m 55. That’s it, you can keep the rest. What do you say Peter?

Peter Renton April 22, 2011 at 9:49 pm

@Dan, If you have no need whatsoever for $1.1 million dollars when you’re 75 I will gladly take it off your hands then. Man, you are eager for a wager, but this one sounds more complicated than most. I would need a LOT more information before I could even make a guess as to whether this is a good idea.

Dan B April 23, 2011 at 12:30 am

You don;t have to look at this as a wager. Just think of it as a reverse annuity with a twist. Besides, life is just a series of wagers anyway. I mean you have car insurance don’t you? You’re wagering you’re going to crash & the insurance company is wagering that you don’t. You win by crashing. Win too often & they won’t bet with you anymore. And of course you’ve already undertaken the largest wager of all………….marriage. So, what’s the big deal. All you need to know is that I’m between 25 & 50 yrs. old. :)

Aaron April 24, 2011 at 10:23 pm

I only invest for the short term. I highly doubt that this fiat currency will be the medium of exchange when I enter my 60s (I am in my late twenties.) I invest 15% of my income to my 401k for retirement, but have little to no faith that I will ever be able to use it.

I am more in favor of investing in a way where I can retrieve my money when I need it rather than in an IRA. I am happy to pay the yearly taxes for the privilege.

Peter, yes taxes are a glaring omission, but you are still going to have to pay them on your IRA. Either on the front end or the back end depending on what IRA you choose. What do you think taxes will be like in 2050?

Peter Renton April 25, 2011 at 11:22 am

@Dan, Yes, I have insurance. I feel like I get good odds from the insurance company. If I am driving my 2004 Nissan Murano and run into a new Aston Martin DB9 they will pay that poor soul for a replacement car and I will not be on the hook. I wouldn’t want to take to the city streets without that kind of protection.

@Aaron, So, the US dollar is going away? That is a bold prediction. Although the value will likely continue to decline for most of this century. This is why it is good to diversify your investments into foreign currencies as well. I happen to have a good chunk of money in Australian dollars, one of the strongest currencies in the world the past five years.

But I have to disagree with you on the IRA issue. With a Roth IRA you never pay taxes on withdrawals, the money grows tax free and you take tax free distributions. For someone like yourself, investing in a Roth IRA will likely save you hundreds of thousands of dollars in taxes in your retirement. Taxes in 2050 will likely be much higher than they are now, which is why a Roth IRA is even more beneficial.

Dan B April 25, 2011 at 12:47 pm

@Peter…………You see they have you brainwashed already. Why don’t you send me three quarters of your car insurance premium & I’ll cover any expenses involving any incident you might have with either of the 2 Aston Martin DB9s that live in Colorado. 1 of which rarely leave their garage. While you’re at it please send me your life insurance premium too & I’ll take care of that as well. I’m willing to take the chance that you’re not going to die anytime soon. If you have anything fun like earthquake insurance then I’d love to have that premium as well. And if you do nothing else please send me just half of all the money you’re planning on spending for extended warranties on anything. I’ll cover all those for you too.

Dan B April 25, 2011 at 1:16 pm

And no I don’t have life insurance. The idea that someone benefits financially from my demise makes me a bit nervous. :)

Peter Renton April 25, 2011 at 2:07 pm

Dan, I don’t consider it brainwashing. I consider it prudent financial management. You may disagree but it is all about a person’s tolerance for risk. If you can pay hundreds of dollars a year and avoid a potential million dollar headache then I say it is worth it. BTW, I agree that buying any extended warranties on electronics or even cars for that matter is a complete waste of money.

As for life insurance, I never really had any until I had kids. But they changed everything. One of my largest assets is my potential future earning power and I want to make sure that asset is protected. Term policies are cheap and are set to expire once the kids are in college.

Dan B April 25, 2011 at 3:58 pm

@Peter……….I was just semi-kidding of course. Then again the best way to protect against that million dollar liability is to “appear” not to have any real money. Without breaking any law of course.

Wait, you only pay hundreds of dollars a year on car insurance for full coverage!

Aaron April 26, 2011 at 6:25 am

I stand corrected on the Roth, but on a side note……Who gets $3,000 back from the government? I always have to pay money every April. I like it that way. Better to have your money in LC or P earning 5% than in the government’s coffers earning 0.00000000000000000000000000%

:)

Peter Renton April 26, 2011 at 6:52 am

@Dan, Old cars and a good driving record has helped reduce our premiums for car insurance.

@Aaron, I completely agree. Giving the government an interest free loan is unwise but the facts remain that tens of millions of Americans do this every year and the average refund is around $3,000.

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