It’s been a couple of weeks since the April 30th tax return deadline has passed. If you’ve setup auto deposit to your bank account, on the CRA website, you would have received your tax refund by now. For many this comes as a bit of a windfall when the money situation is tight. So what should you do with the tax return now that you got back?
Let’s understand why you are getting money back first. The RRSP account is advertised as a way to save for retirement, but the reality of it is that it’s actually a way to defer taxes to a later date. That’s why you’re offered a tax return for contributing. You are getting back the taxes you paid for the amount that you contributed.
The consequence of getting a tax return now is that when money is taken out of the RRSP account in the future, you will have to pay taxes on the withdrawal. Money taken out of an RRSP is treated as earning a regular income. This might be advantageous to people who see themselves going into a lower income bracket, but it’s a terrible idea if you have a defined pension or expect to be generating a larger income due to a large inheritance or investment income.
Alright! Now that we know why we are getting a refund, what are some of the popular things that people do?
With Canadians falling deeper and deeper into debt, one of the popular ways to use the tax return is to pay off that debt. Now this doesn’t seem like such a bad idea, it’s certainly better than spending it on an iPhone, but one would have to wonder, if you can make a contribution to your RRSP why can’t you pay off your debt first?
Putting off debt in favour of saving for retirement seems a bit backwards. In fact, by spending the tax return, this means you are borrowing from your future self to pay for something now. This is something you should avoid doing.
If you are constantly finding yourself behind in debt payments. Budget accordingly. Make sure you don’t exceed your monthly budgets. Set aside money to pay down the debt so that your money is working for you, rather than your debt working against you. Waiting to get a tax return year after year to make up for debt payments means your loans are slowly draining you away with interest payments.
Going On A Buying Spree
When I was younger, I always thought of my tax return as a bonus. It was this one time payment that made me a bit richer in the Spring time. What better way than reward myself some brand new kicks for the summer. Wrong answer young dumb self.
Spending the tax refund is probably the worst move one can do. Spending it is no different than using it to pay off debt, only this time there is nothing that is helping you financially. By spending it on something, it means that you are spending money from your future self.
What do I mean when I keep saying spending from my future self? Quite simple in fact. By spending the tax refund, it’s taking away from the money you will need when you withdraw money from your RRSP. That’s when the taxes, or the refund you received, will be taken back away from the government. Just keep drilling in your head that the RRSP is a tax deferral account and you’ll finally get it.
Save And Invest It
The proper way to use your tax refund is to save and invest it. If you are investing your RRSP contributions for retirement, then you will need the refund that the government pays you back to pay for the taxes when you withdraw the money in the future.
For instance, say you contribute $5,000 into your RRSP while paying in the 20% marginal tax bracket. This will mean that the government will return $1000 back to you as a tax refund. That’s great! You’ve just saved $1000 in taxes.
Now say over the next decade the money in the RRSP grows and it doubles. There’s $10,000 sitting in your RRSP now, but you want to withdraw all of it out for whatever reason. If you are still in the 20% marginal tax bracket, then withdrawing the $10,000 will result in tax bill of $2,000. That’s right the government is going to tax you on your withdrawals!
Now where is the $2,000 coming from? Well, in this case if you had spent the original tax refund, then the money will be coming out of the gains that you have gotten from investing in your RRSP. However, had the original $1,000 tax refund been saved and invested instead, then that $1,000 would also double along with the original RRSP investment. Magically that $1000 is now sitting at $2,000. Tada! That’s exactly the same amount that you need to pay for taxes.
That’s why you should be investing the refund. It allows you to use the gains from the refund to pay for the taxes when withdrawing from the RRSP account.
Understand the RRSP Account
One the biggest misconceptions that Canadians have about the RRSP account is that it was created for the purpose of retirement. That’s a big lie. The sole purpose is to defer taxes to a later date in hopes that you will be paying taxes in a lower tax bracket.
What many people fail to realize when they finally retire is that the money in the RRSP is not really all their money. The government actually has a claim to it in the form of taxes. This is where individuals get caught off guard when they think they have saved up more money than they really have. They may think they have saved up over a quarter million, but in fact, 20% of that money is going to be taxed and taken away by the government (if you’re still in the lowest tax brackets).
That’s why it’s important to understand what the tax refund is all about. The government is very happy when you spend the money now because it helps the economy, but what it ends up doing is taking away from your future wealth.
Now that you know the truth about your tax refund, what are you going to do with your tax refund?