You were a good citizen. You were organized, gathered all of your tax forms, receipts and filed your taxes promptly.
As a result, you are now the recipient of a nice chunk of change from Justin and the Premiers in the form of your tax refund!
Your tax refund might feel like free money, but it is not. In actuality, this is the repayment of an interest-free loan that you gave the government without even knowing it. Throughout the year, you either make periodic remittances if you are self-employed (or otherwise required) or you have tax taken off each paycheque by your employer. Your tax refund is the return of overpayments that you made relative to the income tax that you actually owed at the end of the year. Hence, this is why it is called a refund. Your tax refund was indeed your money all along.
But now, the big question is, “How should I use my tax refund?”
Before you buy that new iPad or fly to Jamaica, here are a handful of recommendations.
How You Should Use Your Tax Refund
1. Pay Down Consumer Debt
Consumer debt is debt related to consumption, instead of debt that is tied to an asset that can appreciate.
This is priority #1. This would likely be priority #1 on any list for that matter. Paying down your consumer debt is so important that it should likely be #1, #2 and #3 on this list.
This prolonged low-interest rate environment that we have lived in seems to have lulled many Canadians into a false sense of security around carrying consumer debt. According to the 2018 BDO Affordability Index, 46% of Canadian households don’t earn enough income to live debt free.
But not all debt is created equal. The largest area of concern is high-interest debt. High-interest debt generally comes in the form of credit cards (up to 20% APR), payday loans (>100% APR and upward), and high-interest lines of credit (10% APR or more). Rates mentioned are illustrative and not a minimum threshold for concern.
If you are carrying high-interest debt, paying it down will almost always be the best use of your funds. You should focus on paying down your debt with the highest interest rate first.
In essence, consumer debt is what you owe for the material things or that you already have or the experiences that you have already had. To put it another way, instead of using your tax refund to buy an iPad, you still need to pay for the iPad that you purchased years ago.
2. Open An RESP For a Family Member
Education costs are continually on the rise. A year of post-secondary education at a Canadian university can cost up to $20,000. Starting to save early in a child’s life is prudent given the rising costs.
RESPs are an excellent way to save for a child’s education for a few reasons.
- Free Money!
The Government of Canada matches 20% of your contributions, up to a maximum of $500 per year. This is called the Canada Education Savings Grant (CESG).
There is also lifetime maximum for CESG contributions that the government will make of $7,200.
- Tax-deferred investment growth
Money held within an RESP grows tax-deferred. Similar to an RRSP, all of the growth of the funds within the RESP has the benefit of tax-deferred compounding. Tax-deferred investment growth has been proven to be a winning wealth builder.
- Taxed in the hands of the beneficiary
Unlike an RRSP, contributions made by yourself into the RESP are not deductible from your income. As such, you will be contributing after-tax dollars into the account, similar to a TFSA.
However, the CESG amounts and the investment income are then taxed in the hands of the beneficiary (i.e. your child or niece/nephew) upon withdrawal. This can provide significant tax savings. Students are typically in a low-income period of their lives during schooling, and they should generally be in a lower tax bracket than the contributor during this time.
These advantages should be capitalized on early and often in the life of the beneficiary to maximize the CESG and tax deferral. Use your tax refund to start an RESP and take the free money!
3. Contribute to your RRSP/TFSA
If you don’t require the free CESG money for a family member, you can shift your attention to your personal savings.
Whether you contribute to your TFSA or your RRSP will vary based on your individual situation. I prepared a rundown on things to consider when answering the question, “Is an RRSP contribution right for me?”
When making your determination of where to put the money, the primary question that you should ask is “When will I need the money?”
Funds in your RRSP are intended for your retirement, but they could also be withdrawn to buy a home using the Home Buyers Plan or to go back to school via the Lifelong Learning Plan.
Another perk of an RRSP contribution is that it can increase your tax refund for next year if you deduct it against your 2019 income.
If you need this money for the near term (other than for purchasing a home or for going back to school), TFSAs provide added flexibility around withdrawals. This is an ideal place to keep your emergency fund. If you do not have an emergency fund in place, then bump this up ahead of the RESP plan in terms of priority.
If you have questions around what option is best for you, you should speak with a financial planner.
4. Mortgage Paydown
The market is sending mixed messages about where interest rates are going in the intermediate term. However, we know that we have been experiencing a prolonged low-interest-rate environment.
The party should come to an end sooner-or-later, and rates could rise.
There are a few key benefits to paying down your mortgage:
- Defence against rising rates
As rates rise, so will your mortgage payments on a variable mortgage. Even if you have a fixed rate mortgage, it will come up for renewal inevitably, and all else being equal, your payments will increase along with the interest rate.
- Guaranteed rate of return
Let’s assume that you have a mortgage rate of 3.5%. By paying down a portion of your mortgage, you have just achieved a guaranteed after-tax return on your investment of 3.5%! I challenge you to find a guaranteed investment that will pay you that rate of return after-tax.
This guarantee, however, doesn’t contemplate foreclosure risk, or any of the other risks associated with homeownership. That said, paying down your mortgage is an excellent way to achieve your long-term financial goals.
- Lower monthly payments
As you lower your outstanding balance, your monthly payments become lower. Some mortgages implement these changes immediately, while others will update the payments a set interval. In either case, when you have less to pay back, you can pay less each month.
- Mortgage renewal flexibility
A lot of digital ink has been used lately discussing the challenge that some are facing renewing their mortgages.
The Government of Canada introduced rules to stress-test an individual’s ability to afford their mortgage payments when rates rise. As interest rates rise, so does the benchmark rate for the stress-test.
By paying down your mortgage, your outstanding balance and future payments will be reduced, and this will ease the challenge of meeting the stress test.
When deciding whether or not to use your tax refund to pay down your mortgage, you should investigate the repayment terms before making your decision. Some are flexible, while some are stringent and may come with fees or penalties. Speak with a professional to understand the implications of making a pre-payment against your mortgage.
5. Get a Fee-Only Financial Plan
Naturally, this is a self-serving recommendation, but I wouldn’t be doing my job if I didn’t mention it.
A financial plan is an investment in your overall financial well-being. Having a solid financial footing sets you up for success in all other aspects of your life.
A good financial plan can help you better understand your spending, ensure that your investment mix matches your risk tolerance, identify if your current savings will allow you to reach your goals, assess your risk management, or map out how to make your savings last through retirement. And let’s face it, if you are reading this article, then you probably have questions about how to optimize your financial situation.
A financial plan can also help you assess each of the above options for the use of your tax refund based on your individual situation.
An additional benefit is that many of Novel’s clients have been able to achieve significant savings on their investments by executing a Novel Fee-Only Financial Plan. This ultimately means that, depending on your current investment products, the cost of a fee-only financial plan can pay for itself, even in the first year! Investment options that can pay for themselves tend to be few and far between in this day and age. Taking steps to secure your financial well-being is an excellent use of your tax refund.
The Brass Tacks On Using Your Tax Refund
Don’t be so quick to spend that tax refund. After all, it was your money to begin with, not the government’s. There are several things that you can do to put that money to work for you. Each of the options have pros and cons, and they may not all be appropriate for your situation. Resist the urge to spend it frivolously and instead use your tax refund wisely. Then again, sometimes you just need to go to Jamaica.
If you would like to schedule a free consultation to discuss your options for maximizing the use of your tax refund, please contact us.