Are you getting money back on your taxes this year? If so, are you taking a trip, going on a shopping spree, or hopefully putting something away for retirement or a rainy day? If you are taking the latter course where should you invest your tax refund? Investing excess cash such as a tax refund should be routine for every investor. This money will stay put until you are no longer working or when you really need it. Here is where you need to apply the principles of value investing. The skill of long term investing is more in the process than in picking today’s bright shiny stock tip. Intrinsic value is the valuation that successful long term investors use to pick profitable long term investments. We wrote about this concept as it applies to stocks.
Benjamin Graham presented investors with a formula for calculating intrinsic stock value in 1962 and modified it in 1974. The 1974 version considers the following:
- Earnings per share, EPS, for the preceding twelve months
- A constant of 8.5 representing an expected price to earnings ratio, P/E ratio, for a company that is not growing
- An estimate of long term growth, five years = g
- A constant of 4.4 which was the average yield of high grade corporate bonds in the early 1960 decade
- The current yield of AAA corporate bonds = Y
- Where V = intrinsic value
The formula is as follows:
V = (EPS x (8.5 + 2g) x 4.4)/Y
The way the investors were encouraged to use intrinsic value was to derive what is referred to as a Relative Graham Value, RGV. This is to divide the calculated intrinsic value of the stock by its current price. If the result, the RGV, is less than one the stock is overvalued and a bad investment and if the ratio is above one it is undervalued and may be a good investment.
Where Should You Invest Your Tax Refund
If You Want to Reduce Your Tax Burden
When you invest your tax refund you want to put it in something that will appreciate over the years. This is accomplished by picking an investment that is likely to provide a healthy return on investment year after year. And it is accomplished by reducing the overhead of investing. This means minimizing fees and commissions and minimizing taxes as well. In this regard consider an IRA or 401K. Years ago we looked a traditional IRA versus a Roth IRA.
In general one can invest IRA assets in common stocks, bonds, mutual funds, bank certificates of deposit, or real estate. All such investments through a Roth IRA versus a traditional IRA must meet the specific requirements of the Internal Revenue Service. As a rule there are more types of investments that can be made in a Roth IRA than in other types of tax advantaged retirement plans such as pensions, profit sharing accounts, 401Ks, etc. What is available may depend on the trustee of the account. For example, a bank may only offer CDs. A stock broker may only offer stocks. And, mutual funds will obviously only offer mutual funds.
This is where you want to choose a profitable investment, invest one time, and leave it alone to appreciate over the years, tax free, and then pay your taxes after retirement when you are in a lower tax bracket.