What should you do with your tax refund?
As another RRSP season comes to an end, tax season is just around the corner and T4’s, T3’s, and RRSP receipts are filing in. Many readers have asked what’s the best thing for me to do with my tax refunds.
Principles of cashflow
The answer lies in something I call the principles of cashflow. We all have a certain amount of incoming cash flow. Unfortunately for most of us, this is not unlimited. We only have a certain amount coming in, usually in the form of a regular paycheque. What we must then do is ensure that our outflow (otherwise known as expenses) like taxes, mortgage payments, utilities, car payments, gas, food, entertainment, etc. does not exceed our inflow of cash. I know this sounds basic but budgeting is one of the basic elements of financial planning. In the book, the Millionaire Next Door by Thomas Stanley, one of the common traits of the wealthy is that know where they spend their money. Understanding cash flow will help you to determine where the best place for your money is.
Three types of expenditures
Ultimately, whatever you decide to do with your money can be broken down into 3 basic categories of expenditures:
- No value expenditures – Once your cash flow is used, the money is gone. I think everyone understands what I mean. Things like food, utilities, clothes, entertainment, etc. These types of expenditures have no real value to them and do not contribute to building future wealth. In this category, there are necessary expenditures like food but sometimes there are far too many unnecessary expenditures like entertainment. Using your cashflow for too many unnecessary things is often fun but not productive.
- Depreciating expenditures – In this category, the item that you purchase may have value but really that value depreciates over time. The most common depreciating expenditure is a car. Most of us consider a car an asset because it has value but every year, the cars that we own have less and less value. The reason is that cars depreciate and often faster than we would like them to. Obviously, a depreciating asset is better for wealth building because it at least contributes to our net worth.
- Appreciating expenditures – Using your money in this category is the most productive towards wealth building. Assets like GICs, Real Estate, and even Mutual Funds go up in value over time. Using your cashflow for these types of investments will be your most fruitful use of your money. Often, they are not as fun or exciting, as spending money on that new big screen TV or fancy car but it is the best for improving your financial picture.
Look at your bottom line
One of the key benchmarks in your financial planning is your net worth. Your net worth is simply what you own less than what you owe. One of everyone’s goals in financial planning is to increase your net worth year after year. To do that, you must know what your net worth is. If you do not know what your net worth is, take some time this weekend to write down all the things you own (that has financial value) on one side of a piece of paper. Then on the other side write down all the things that you owe (mortgages, credit cards, lines of credit, etc.).
Once you know what your net worth is, the rest is simple. You must either increase the things you own or decrease the things you owe. Obviously, in building the things you own, you will be far better off owning appreciable assets because they work for you. Depreciable assets work against you and no valuable items should not show up on your net worth statement.
Back to the question
So what should you do with your tax refund? The answer should be the same answer to what should you do with your cash flow?
The best things to do with your tax refund are using it productively towards building your net worth. In my opinion, take a look at what I call the principles of cashflow:
- Buy RRSPs
- Pay down high-interest debt (credit cards)
- Pay down non-deductible debt
- Invest outside RRSPs (mutual funds, GICs, etc)
- Pay down deductible debt
You’ve heard me say it before and you will hear me say it again, it is all “Simple, not Easy”. All this stuff is really simple and full of common sense. If that’s the case, then why don’t more people do it? It’s not easy to do. Financial planning is all about tradeoffs and discipline. The people who succeed are the ones who just do it!