And nine more smart things you can do with your refund
Whether it arrives by mailbox or inbox, a tax refund can feel like “found money.” But alas, it’s not; it’s basically an overpayment of tax that the government eventually gives back to you – at a zero rate of return.
For many of us, it’s the result of payroll taxes being withheld during the year based on assumed annual income. The full picture only becomes clear once your tax return is filed and all credits and deductions are fully accounted for.
When the refund does arrive, what you do with it can have significant long-term implications. Contributing at least some of it to a registered retirement savings plan (RRSP) could be a way to systematically pre-pay future tax on the plan. Here are the numbers to illustrate that strategy and a few more tax-savvy options to consider.
1. Grossing-up your RRSP
The apparent simplicity of RRSP arithmetic can be deceptive. For a person at a 40% marginal tax rate, a $1,000 contribution will generate a $400 refund. But that is literally only half the story, as the eventual drawdown will be taxable, netting right back to $600 spendable. Some savers may be quite content with that, knowing that in the meanwhile growth will be enhanced by the tax-deferred nature of a registered account.
On the other hand, some of that future tax liability could be pre-funded by contributing the refund back into an RRSP. To give full effect to this, each successive refund ($400 + $160 + $64 + …) would have to be similarly applied. In truth, this is simply an increase to annual savings but with a specific purpose in mind. Leaving aside investment returns, this would build the principal towards $1,667 in this example, which nets to $1,000 spendable.
Now obviously a person’s tax bracket can vary over time, with the key expectation of being in a lower bracket in retirement. Rather than being a drawback to a pre-funding strategy, it makes even greater use of tax breaks in high-bracket years to fund future low-bracket retirement-income years.
Given that tax refunds are themselves tax-free, there is no drain on future income, so the process can effectively be self-funding. It takes some discipline, but ideally a conscientious savings habit and a tax pre-funding strategy could operate in concert on an ongoing basis.
Reduced withholding at source
For some, a refund may instead be viewed as cash that had been needed for current expenses, but was trapped in the tax system. If that’s so, an alternative is to file Canada Revenue Agency Form T-1213 to reduce tax deductions at source. In our example, this would have released the $400 as cash flow during the year, though the net RRSP contribution is left at $1,000.
Alternatively, if the household budget can bear it, the pre-funding strategy could be coordinated with Form T-1213. In our example, the RRSP contribution would need to be $1,667 presently, as opposed to building in that direction over the years.
2. Spousal RRSP
A spousal RRSP builds on the use of an RRSP to arbitrage from high to low tax brackets across time by also doing so across taxpayers – to a spouse expected to be at a lower future tax bracket.
3. Pay down discretionary non-deductible debt
Regardless why it’s there, this kind of debt can often compound against us faster than we can accumulate savings. Eliminate such costly commitments as soon as is manageable.
4. Retire RRSP loan in the current year
An RRSP loan can help get money into an RRSP, but if not paid off in the current year, it puts a strain on future years’ living expenses and savings. As well, the interest is non-deductible.
5. Mortgage reduction
Importantly, a mortgage funds future housing, but principal and interest are non-deductible. Retiring a mortgage allows more of a monthly budget to be devoted to retirement savings.
6. Tax-free savings account (TFSA)
Funded out of after-tax money, the TFSA allows tax-free growth and tax-free withdrawals. The annual allotment of TFSA room for 2016 is $5,500.
7. Registered educations savings plan (RESP)
An RESP boosts education saving through income splitting, tax sheltering and government grants of up to 20% federally, with some provinces offering further financial support.
8. Registered disability savings plan (RDSP)
Families with disability issues can face large financial challenges. The RDSP enables income splitting, tax sheltering, free government bonds and up to 300% in matching grants.
9. Non-registered investments
Registered savings form the core of retirement savings. Projected spending patterns may show a need to supplement that, and investing a refund can get that part of a plan underway.
10. Live it up … a bit
After all, saving is just spending-in-waiting – but it’s a good idea to try to keep it in balance.