05/20/2014 03:06 pm ET Updated Jul 20, 2014

How Should You Invest Your Tax Refund?

By Paula Pant, WiserAdvisor contributor

Hooray, you've received a tax refund!

Another "hooray!" because you're financially savvy. You've decided to invest this money. Putting your dollars to work for you is always a smart decision, so congratulations on making this choice.

But now, what should you do?

If you're new to investing, the choices can seem overwhelming. Here's an easy-to-follow guide to help you navigate the investment waters. Follow these tips, and your tax refund will be hard at work for you in no time.

1. Buy an Index Fund

First things first. There are two different kinds of mutual funds you can invest in: actively managed funds and passively managed (or "index") funds.

  • Actively Managed Funds: As the name suggests, actively managed funds are more "hands on." They're managed by a team that decides when and where to invest the fund's money. The hope is that such active management will enable the fund to beat the market average and give you better returns.
  • Index Funds: Index funds, on the other hand, simply track the market index. As a result, an index fund's performance reflects current rises and falls in the market. This may seem like it would give you a worse return than an active fund, but consider this: Active funds incur hefty taxes and fees, which can take a bite out of any return they bring you. And historically, active funds are not proven to perform any better than index funds. In fact, they can actually wind up costing you tens of thousands of dollars (depending on the size of your portfolio), because you will continue to pay high fees whether the fund is performing well or not.

Statistics have shown time and again that active funds rarely "beat" the market index -- in fact, they often do worse -- so save yourself the high fees and opt for an index fund.

2. Diversify

Diversification is key to lowering your overall investment risk and getting the best bang for your buck.

At a minimum, you should diversify between stocks and bonds. A simple way to represent this would be to own two index funds: one that tracks the overall stock market (like the S&P 500) and another that tracks the overall bond market (like the Barclay's Aggregate Index). If you want to get a little more complex, however, your stocks should be further diversified based on:

  • Size: Aim for a mix of all large-cap stocks (companies with8 billion+ market caps), mid-cap stocks (companies with1-8 billion caps) and small-cap stocks (companies with caps less than1 billion).
  • Style: Include both growth funds (those that promise a higher return on investment based on growth projections) and value funds (those whose current market value doesn't necessarily capture their fundamental worth).
  • Location: Don't just stick to U.S. stocks; expand your focus to developed markets. like Europe, and emerging markets, like China and India.
What about your bond allocation? Consider investing in a mix of:
  • Treasury Bonds: These are your safest best.
  • Corporate Bonds: These are slightly less safe but can give you a higher return.
  • "Junk" Bonds: These are the riskiest investment but have the highest potential return.

Which percentage of your portfolio should each category represent? The answer depends on your age, the amount of time you'll be investing and your risk tolerance. Here's a broad rule of thumb: 110 minus your age is the proportion of your portfolio that should get invested in stocks, with the remainder in bonds.

3. Taxable vs. Tax-Advantaged Accounts

You also need to consider the tax ramifications of your investments.

  • Taxable: A normal brokerage account is "taxable" -- meaning you'll invest after-tax dollars, and you'll pay taxes on your gains and dividends.
  • Tax-Deferred: Money in a 401(k) or Traditional IRA is "tax-deferred." This means you'll defer income tax today, and the money will grow tax-deferred. You will, however, pay a bigger tax bill when you withdraw any money during retirement, as you'll be paying taxes on both the income as well as the capital gains and dividends.
  • Tax-Exempt: Money in a Roth 401(k) or Roth IRA is "tax-exempt." You'll pay income tax today, but the money will grow tax-free, and you won't pay a dime when you withdraw -- not even on the capital gains and dividends.

Your options here depend on your personal preference. You can put the money into a Traditional or Roth IRA, or you can live on that money and ask your HR Department to put more of your paycheck into your company's 401(k) (thereby "investing the tax refund" in a roundabout way). Take some time and consider which route would make the most sense for your financial situation.

Time to Get Started

Those are the basics you need to know to start investing. Not so tricky, right? Now put that money to work for you -- and enjoy investing that tax refund!

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