What to do with your tax refund?
Are you getting a tax refund this year? What do you plan to do with your tax refund?
For most people, the first inclination is that a tax refund is a bonus and as a result, we rush out to use it for something that gives us emotional gratification. Spending the bonus can make us feel good but there may be some smarter things to do with the money.
If you are interested in using the refund for building wealth and helping your finances, one of the key benchmarks in financial planning is to look at your net worth. Your net worth is simply what you own less than what you owe. One of everyone’s goals in financial planning should be to simply increase your net worth year after year. To do that, you must first know what your net worth is. If you don’t know what your net worth is, take a piece of paper and one one side write down all the things you own (that has financial value). Then on the other side write down all the things that you owe (mortgages, credit cards, lines of credit, etc.). This is also known as assets and liabilities.
Related article: Calculate your net worth
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 appreciating assets because they work for you and your net worth.
So back to the question . . . what should you do with your tax refund? If you are looking to further your finances, consider some of these principles of cashflow:
Invest in RRSPs
One way to increase your assets is to invest your refund back into RRSPs. This is simple and smart financial planning. It may not be as much fun as going out to buy that new toy, but investing money is a good habit and taking advantage of some of the tax benefits of RRSPs is a great strategy for most people.
Related article: RRSP Guide
Investing now has advantages over waiting until January or February of the following year. It forces you to save instead of having to find the funds from other sources in the future. If you are investing in RRSPs early, you may want to apply for a reduction of taxes at source.
Pay off non-deductible debt
Paying off debt might be one of the best investments you can make particularly if that debt is non-deductible. For example, say you have a loan you are paying 5% interest. On an after-tax basis, that interest is really costing you 6% to 9% depending on what your marginal tax rate is. Unfortunately, when you earn a dollar, you must pay tax and therefore, you will only have 55 to 75 cents after tax to go towards the interest.
The key to the debt reduction strategy is not to go back into debt. Far too often, I see people that commit to using their tax refunds to pay off debts like credit cards or personal loans only to go back into debt. If this sounds like you, you might be better off investing your refund into RRSPs as a method of forced savings.
Pay off high-interest debt
If paying off a 5% debt is good, paying of credit cards charging 18% to 28% is obviously better. The credit card math will work against you every time especially if you are paying 18% or more in interest. High interest debt like credit card debt is the worst debt to have which makes it so important to pay down those debts. If you are carrying a balance on your credit cards, it’s so important to consider paying them down with your tax refund.
Related article: Ways to pay off your credit cards
Paying down this debt is always a great place to start if you have extra money (like a tax refund) but it’s also important that you have the discipline to NOT accumulate the debt again once you pay it down.
Invest in a Tax-Free Savings Account (TFSA)
Tax-Free Savings Accounts were introduced to Canadians in 2009. Everything about the TFSA is awesome. It’s TAX-FREE when you put money in, TAX-FREE when you take it out, TAX-FREE when the money grows, TAX-FREE if you die. There are limits as to how much you can put into the TFSA because they are such awesome accounts.
Related article: Investing your TFSAs
As great as the TFSA is, there are 2 common debates:
Getting a refund may not the best thing
While most of us would rather get a refund than have to pay any amount of tax at tax time, you may not be making the most efficient use of your money.
In fact, getting a refund really means you have given the government an interest-free loan for 12 to 15 months. You would have been better off investing that money or using it for your finances instead of lending it to the government tax-free. For some people, tax refunds are a means of forced savings but if you are disciplined at financial management, you may want to apply for a reduction of taxes at source. This will force your employer to withhold fewer taxes off your paycheck so that this money is in your hands instead of the hands of the government (CRA).
To apply to reduce tax deductions at source, you can fill out a form called the T1213 which can be found on the CRA website.
Simple not easy
Building wealth is really simple. Spend less than you earn and be sure to force yourself to ‘spend’ your money on assets that build wealth as opposed to assets that have no wealth. While this is really simple, it is not easy to do because we get more emotional satisfaction out of using the money for things that either depreciate in value or have no financial value.
As you get that refund this year, think twice about what you want to do with that money. If you have already maximized the RRSP and have no debts, congratulations – spend away.