Tax season is just starting for most people and they’re starting to think about whether they’ll owe money or get a refund.
If you’re lucky you’ll get a refund – but what you do with your tax refund is just as important as getting one. This is because for most people a tax refund is seen as a bonus – an extra amount of money they weren’t expecting. Some have a tendency to spend it on things they want but may not need like a new car, a vacation or the latest smart phone. But if you’re receiving a tax refund because of an RRSP contribution, the worst thing you can do is spend the money on something you don’t need.
Paying Off Debt
It should be fairly obvious to most people that paying down debt should be made a priority with any available money. If you’re not sure which debt to pay down first a good rule of thumb is to start with the highest interest debt and work your way down from there. Consumer debt such as credit cards are the worst because the interest rates are so high, so if possible you should pay it down as quickly as possible and go beyond the minimum monthly payment (or better yet – pay it all off entirely).
Another option for the money is to put it towards your RRSP. This option may not be so obvious for people who have already made RRSP contributions and will receive a tax refund because of it.
But an RRSP contribution will reduce your taxable income when you file your return next spring, which means you can invest the money now and (potentially) get a tax refund later when you file.
Of course before you make an RRSP contribution you’ll want to make sure you have the available contribution room.
The TFSA is an excellent savings vehicle that can be used to your advantage. It’s considered one of the best ways to save for your retirement and for good reason – even though contributions are not deductible for taxes, all withdrawals can be made tax-free. This means if you start now by putting money into your TFSA you can take advantage of tax-free investment income for years to come.
Even small amounts can make a difference. Contributing $25 per week to a TFSA for 10 years means you could have almost $20,000 in 10 years (assuming a 5% rate of return). And when the money is taken out the contribution room isn’t lost but instead gets added to the contribution room for next year.
If you own a home and have a mortgage on it, you may want to consider putting the tax refund towards the mortgage principal. Paying down debt of any kind is a guaranteed rate of return, so if you are unsure about investing and need to make a decision fast, consider paying down your mortgage to get a guaranteed return on your money. The markets go up and down with no investment guarantees but paying down debt means you are guaranteeing you will reduce your interest costs in the future.
Non-Registered Investment Accounts
If you have no debt, no mortgage and both your RRSP and TFSA are maxed out – you’re in a great position. If you have a tax refund coming your way you may want to open a non-registered investment account. The income earned in a non-registered account is taxable but tax avoidance shouldn’t be used as the main factor behind your investment decisions. No one likes to pay taxes but paying taxes on some investment income is better than paying $0 taxes on $0 income.
Start a Business
If you’ve always wanted to be an entrepreneur but never had the money available to get something going, maybe a tax refund is your chance to get the ball rolling. Any business that’s worthwhile takes a ton of time, effort and dedication, so there could potentially be a lifestyle change when starting a business aside from your finances. Starting a business is also risky, and you could lose your entire tax refund, so you’ll want to make sure you do your research before diving in. As an accountant I see small businesses often – some of them thrive while others fail. But the ones that are successful have one thing in common – they live and breathe their business and are ‘on’ almost 24-7. It’s something to consider if you’re looking for balance in your life or have other commitments that are more important.
This past year I managed to reach the contribution limits for both my RRSP and TFSA, which means a small refund is coming my way. My plan is to put the money into my wife’s TFSA so that we can start to earn more tax-free dividends. The investment strategy for this account will likely be the same – investing in blue chip dividend stocks for long term growth with the odd index fund mixed in.
Conclusion – a tax refund shouldn’t be seen as a windfall (in my opinion) and should be used to either invest in a registered account or pay down debt. That being said I think it’s totally fine to set aside a small amount for fun stuff.