Tag: Tax refund

What to do with your tax refund

Saving is the way to pay yourself back, over and over

At the risk of taking the fun out of tax season – stop laughing, keep reading – I suggest that you devote your tax refund toward savings.  Okay, spend some, but allow me to make my case for making saving your first priority.

A tax refund is a kind of forced savings already.  In essence, the taxes that were withheld over the course of last year were more than necessary to fulfill your annual income tax obligation.  Once the full calculation has hit the books with the filing of your tax return, the government sends back that overage.

Commonly for those whose income is mainly employment-related, the refund arises due to RRSP contributions.  Your employer would have reduced its withholding where it knew about contributions to workplace pensions and RRSPs, but it would not have known to do that for RRSP contributions you made outside of work.  For example, at a 40% tax bracket, a $1,000 contribution to your own RRSP reduces your reportable income by that amount, so you have $400 coming to you.

As well, you likely made RRSP contributions in January and February, and are allowed to apply those contributions against last year’s income.  Assuming so, that gets you your tax break as early as possible, but let’s pause and think about the mechanics involved in that.

For those workplace RRSPs, you are using some of your 2018 income to reduce 2017 income, in effect paying last year’s taxes with this year’s income.  That can put growing pressure on your cash flow from year to year, and put you in an especially difficult bind if you lose your job.

At a minimum, save the refund related to those first 60 days, whether it’s simply set aside in a tax-free savings account or it goes as a further RRSP contribution.  If it is the latter, your larger refund next year can help reverse you out of catch-up mode with your taxes.  Supplement that with the refund from your other RRSP deposits and you’ll be ahead on both your taxes and your savings.

Your tax refund pre-funding an RRSP tax bill

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.

Depositing an employee bonus directly to RRSP

Implications of ‘no taxes withheld’

It’s February 2016, and many fortunate employees will be looking forward to the payment of their 2015 year-end bonus.  Particularly in sales roles where year-end figures dictate the amount of those bonuses, payments necessarily occur after December 31st.

Most employers will target to have those bonuses paid before the end of February, in part to enable the employee to use those funds to make an RRSP contribution that can be applied against the prior year’s income.  Often employers will go even further by offering to route the gross amount of the bonus – that is, with no federal or provincial income tax withheld – directly into an employee’s workplace group RRSP.  

For a conscientious RRSP saver, this is a great way to assure that contributions are being systematically socked away.  However, one must be careful to understand the mechanics of this process, in order not to receive a nasty tax surprise later. 

Timing and source of RRSP deposit

By the way, the 60-day deadline this year is Monday, February 29, 2016 to be able to claim against 2015 income.  For our ‘no-taxes-withheld’ bonus deposited directly to an RRSP, that means you will be using income taxable in 2016 to reduce income taxable in 2015.  

To illustrate, let’s assume for simplicity that Bonnie claimed no RRSP contributions for 2014, and her marginal tax rate is 40% at all times in this example.  She earned a base salary of $90,000 paid in 2015, and bonus of $10,000 paid in February 2016.  By making the RRSP contribution in February 2016, she reduced her 2015 taxable income to $80,000, yielding a tax refund of $4,000.  If Bonnie earns the same $90,000 base this year, her total income will be $100,000 in 2016.  

Unfortunately, Bonnie is terminated at the end of 2016, and by her employment contract is not entitled to any further bonus payment.  

Tax refund and next year’s tax return

It now comes to tax filing time in April 2017.  Bonnie’s employer perfectly withheld the tax due based on her $90,000 base, but Bonnie actually earned $100,000 in 2016.  She now owes another $4,000 in tax.  If Bonnie had the foresight to set aside the refund money when she received it in the spring of 2016, she would have the exact cash necessary to pay that difference.

Though somewhat in hindsight, this begs the question: what should Bonnie actually do with the tax refund?  A common recommendation is to make a further RRSP contribution with any refund that is generated from an RRSP contribution.  Apart from cultivating a savings habit, this enables the person to boost the RRSP each year by repeatedly applying the tax refunds to, in a sense, pre-fund the tax liability on the eventual drawdown.   

In this case however, had Bonnie made that second RRSP contribution, it would have generated a corresponding refund of $1,600.  That certainly helps build her retirement savings, but from a cash flow perspective she would still be $2,400 short of the $4,000 she needs to pay her 2016 tax bill on that bonus payment.

Real, or could it be worse?

On a rolling annual basis, if Bonnie has a consistent income and RRSP deposit habit, this phenomenon may never even be noticed, at least not until the year (or rather the year after) she retires.  

On the negative side of things, what if Bonnie had a $40,000 one-time/exception bonus one year that she used to catch up carried forward RRSP room?  This could play havoc with her cash flow when it comes to filing her taxes the following year.

As a final note, be aware that premiums for Canada Pension Plan and Employment Insurance are applicable to bonus payments.  That means that if the full bonus is directed to an RRSP, the employer will be taking those CPP and EI deductions out of the employee’s regular pay.  Though not as substantial as the income tax implications, this helps explain the slightly lighter regular pay cheque the employee would receive at February month-end.