Your tax refund: It's more than you think
Longer days, melting snow and the sudden reminder that under that tarp on the patio is a grill that transforms you into a spatula-wielding master chef. These telltale signs can mean only one thing: a new season has arrived. That’s right, tax season.
What are you doing with your refund?
Around this time of year, many Canadians start pondering how much they’re getting back from the taxman, and what they should do with this “extra” cash. Buy a new couch? Take a trip to the Bahamas?
In a survey last year by the Chartered Professional Accountants of Canada, nearly 30 per cent of Canadians said they would use their refund to whittle down debt. About 20 per cent said would put it towards day-to-day expenses, while another 20 percent said they would save or invest the money. Other respondents said they would apply their refund towards home improvements, a vacation, a child’s education, a non-essential purchase, or a big-ticket item such as a TV1.
So what about you? Got any plans yet for this year’s tax refund? Here’s a good one: put it into your RRSP.
I know, I know. You’re probably already contributing to an RRSP, so why would you need to put your tax refund there? You’ve got a wish list of things you need and want to buy. And after a long and particularly cold winter, why shouldn’t you take your family to a much-needed holiday in the sun?
Let’s put those arguments aside for a second and look at what happens when you invest your tax refund into your retirement plan.
Let’s assume your income puts you in a 30 per cent tax bracket. You contributed $1,000 to an RRSP, which gives you a $300 tax refund. When your refund cheque arrives, you immediately deposit the $300 into your RRSP.
What happens next is magical. Your $1,000 contribution increases by 30 per cent (i.e. your refund) – significantly more than most market returns – and your RRSP assets are now 30 per cent higher.
The next year, that $300 tax refund you put into your RRSP produces another 30 per cent refund, which amounts to $90. So you get a refund on your refund. Again you put this $90 refund right back into your RRSP.
Your initial $1,000 contribution has now grown by 39 per cent, and the benefits continue to roll in. The next year, the $90 you invested gives you another 30 per cent tax refund of $27, which you also put back into your RRSP. Over a three-year period, your initial RRSP contribution of $1,000 has increased to $1,417, representing growth of 41.7 per cent – not accounting for any market driven influences.
So your 30 per cent tax refund is, at this point, actually a 41.7 per cent benefit. Quite remarkable isn’t it? And, all because you viewed your tax refund as a strategic component of your retirement plan rather than a gift of extra cash2.
Of course, putting your tax refund into an RRSP isn’t the only wise course of action. You can also open a Tax-Free Savings Account (TFSA), which allows your money to grow tax-free and doesn’t incur a tax hit when you withdraw your funds. Just keep in mind that TFSA deposits don’t generate a tax refund.
Ideally, you should be using a TFSA after you’ve maximized your RRSP contributions, but a TFSA can supplement your overall financial planning strategy in various other ways.
You can also apply your tax refund to debt management, a key pillar of a sound financial plan. Interest on debt typically accumulates at a higher rate of interest and often compounds at a faster rate. So if your debt is getting out of hand, it’s a good idea to use your tax refund to pay off your higher-interest loans or credit cards.
These options may not seem as exciting as that new couch you’re hoping to buy, or that sunny vacation you and your family are just dying to take after months of snow and freezing temperatures. But do the math on what happens when you invest this year’s tax refund – and your refund from subsequent years – into an RRSP.
It’s not a walk on the beach, but the outcomes can be just as amazing.
Contact us to discuss the various opportunities for you to utilize your tax refund so you can maximize its benefits.