It’s tax season, a time when many people’s thoughts turn towards their tax refund and what they’ll do with it. Should you put it towards your mortgage, add it to your RRSP or make a TFSA contribution?
While many financial institutions often recommend one of those options, we might suggest a different one: don’t get a tax refund at all.
This may sound counterintuitive; after all, isn’t it great to receive a big tax refund, which you can use in so many ways? Not necessarily; let’s take a look at why it’s better not to get a tax refund and instead receive extra money in your paycheque, throughout the year. We’ll also look at how you can reduce your at-source tax deductions and what to do with that extra money.
Why would you get a tax refund?
Let’s take a look at why people receive tax refunds; after all, most employed people pay tax at source. The money you receive in your paycheque has normally had tax deductions taken from it (as well as CPP and EI contributions) by your company’s payroll department. The tax withheld is an estimate of your tax liability to the government and is sent to the Canada Revenue Agency on your behalf. So, why would you get a tax refund?
Your payroll department doesn’t take into account several common payments that you make over the year which can be claimed on your tax return to reduce your tax owing. These include:
- Personal (non-work related) RRSP contributions
- Child-care expenses
- Spousal support
- Charitable donations
If you make considerable amounts of these payments , you could receive a fairly hefty tax refund.
Why is it better not to receive a tax refund?
Getting a large tax refund can be considered inefficient tax planning. Every month, you pay more tax than you need to, and that money sits in the CRA’s coffers, making the government interest, instead of contributing towards your financial plan. For some of that money, it could take as long as 16 months before you get it back, depending on when you file your taxes.
Let’s say, on May 1, you receive a tax refund of $5,040 for your previous year’s tax contributions. This is certainly a tidy windfall and enough money to make a significant contribution to some of your savings goals. However, what would happen if you received $420 in extra cash every month instead of big tax refund?
Let’s say you invested this additional money and earned a return of 5%. By the following May 1, your capital invested for the previous year would still be $5,040; however, that amount would have grown to $5,243, an extra $203. Now, imagine how much extra your investments would grow over 10, 20 or even 30 years, when the power of compound returns really kicks in. Getting that money working for you sooner could help you reach your financial goals much faster.
How to reduce your paycheque tax deductions
To reduce your payroll deductions, it’s actually a fairly simple process. You fill out the Government of Canada form T1213 Request to Reduce Tax Deductions at Source and send the completed form to your nearest CRA tax centre (you can find yours here).
The government will then send you an approval to reduce your withholdings (if you qualify), which you should send to your employer’s payroll department. Depending on the amount, you could see a significant increase in your take-home pay. While this process can be done at any time in the year, this is definitely a case of the sooner in the year you get this done, the better.
What should you do with the extra dollars in your paycheque?
Many financial institutions often recommend that you put your tax refund into an RRSP or use it to pay down your mortgage, which could be the correct choices. The fact is, though, that the best way to use the extra money will be different for different people.
Let’s take a look at the options that might be available to you.
Increasing your RRSP contributions: If you need to boost your retirement savings, increasing your RRSP contributions could be an ideal choice. The longer you save, the more you benefit from tax-deferred growth. You’ll also receive an immediate tax benefit, as your contributions will reduce your taxable income. Just be sure that you have sufficient contribution room, otherwise you may have to pay overcontribution penalties.
Maximizing your Tax-Free Savings Account (TFSA): The TFSA contribution limit increased in 2023, to $6,500. If you were aged 18-plus in 2009, have never contributed to a TFSA and have been a resident of Canada from 2009 onwards, you’ll be able to contribute up to $88,000 in 2023. While contributions to a TFSA are not tax deductible, growth in the account is typically tax free (including interest, capital gains and dividends), and you can withdraw funds at any time with no penalty or tax to pay. The TFSA is a very flexible saving option and should be part of everyone’s financial plan. Find out more about TFSA contribution limits and six benefits of the TFSA.
Growing a Registered Education Savings Plan (RESP): If you have kids and want to save for their post-secondary education, an RESP could be an ideal option. You’ll receive up to $7,200 in lifetime government grants, and the savings grow on a tax-deferred basis. Find out more about the benefits of RESPs.
Building an emergency fund: If you don’t have an emergency fund, you should consider starting one with the extra money in your paycheque. Without an emergency fund, a large, unexpected expense can damage the best financial plans. Find out why an emergency fund is important and how to build one quickly. In many instances, your TFSA can be a great place to keep some or all of your emergency funds.
Paying off high interest debt: If you carry balances on credit cards or high-interest lines of credit, it might be the best option to pay those off before you do anything else with your extra money. You’re unlikely to earn returns from investing that can beat the interest you’re paying on this debt, so this could be a simple decision.
Paying your mortgage off faster: For some people, being mortgage-free, as fast as possible, is a priority. However, if your mortgage interest rate is considerably lower than the after-tax returns you could make on investments, you may want to consider other options.
Going to Vegas and putting it all on red: Just kidding. Put it all on black. Still just kidding. Don’t go to Vegas.
Before you make any decisions, talk to your advisor
Having extra money to save every month is always a good thing, no matter what your financial plan or goals are. However, it’s important to know what the best use of that money might be. Your IG Advisor can look at your overall financial situation and suggest the most effective use of the money for your unique circumstances, both for the short and long term.
If you’re thinking of reducing your tax deductions at source, speak with your IG Advisor today to discuss the best options for you. If you don’t have an IG Advisor, you can find one here.