Tax refunds are generated when you have more tax deducted from your pay cheques than what you end up owing the government. This can happen when you claim tax credits and amounts you didn’t consider until you got around to preparing your taxes, such as medical expenses or if you make RRSP contributions.
While it may be tempting to spend your refund on a trip or a new designer outfit (and we’re not saying you shouldn’t!), but there are many ways to use the money that’ll actually improve your financial health and future — and just might help you sleep better.
Improve Your Financial Health
You can use your refund to improve your financial situation overall, whether your goals are retirement savings, buying a home or continuing your education. But, surprisingly, applying your refund directly may not be the smartest move when you look at the big picture.
Attacking high-interest debt is generally regarded as the best move you can make toward financial health unless you happen to be in an industry which has weak job security, or are often between jobs, then you might be better suited to keep those funds for emergencies.
You could also use that refund to knock off past-due bills before you address high-interest credit cards because keeping current with day-to-day bills protects your credit score and future credit, or you could consolidate all of your debts into a lower-interest loan, and use the finds to pay that new monthly balance.
Put Money Towards Your Mortgage
If you’re on top of your bills and credit cards, other strategies can maximize the value of your tax refund. One of those strategies: Homeowners can take advantage of annual lump sum contributions to their mortgages. Most mortgages permit extra payments of 5 to 25% of the mortgage value each year without penalty.
Save for Education
Registered education savings plans (RESPs) are another clever refund destination for Canadian families concerned with the rising costs of post-secondary education. A parent can set up an RESP for his child and make contributions to the plan. Although this doesn’t result in an immediate tax deduction, investment income is sheltered while it’s in an RESP. Your child must pay tax on the investment’s earnings while he’s in school, but contribution amounts remain tax-free on payout.
You may decide to use refund dollars to resume your own education. You can now claim certain education fees against your income tax for the years you’re in school. These credits return only a portion of the amount you spend, but you can transfer unused credits to your spouse or carry them forward to future tax years. How much these amounts add up to depends on whether you’re a full-time or part-time student and the number of months you’re enrolled.
Put Away Money for Retirement
Registered retirement savings plan (RRSP) contributions can create larger refunds, and you can use the cash that comes back to you to bolster retirement savings. David Chilton, author of “The Wealthy Barber,” advocates for this option, telling the Globe and Mail that spending a refund on something other than additional RRSP shares defeats the prime advantage of earning the immediate tax savings.
Also good to look at is the Tax-Free Savings Account (TFSA) which allows contributions of up to $6,000 annually in tax-free savings. Contribution room goes back to the start of the program. There is no immediate tax break – TFSAs are purchased with after-tax dollars – so there’s no effect on refund amounts in the contribution year.
Plopping a refund into a TFSA creates an account that can grow the same way an RRSP does, however, while investment growth remains sheltered and tax-free. When you withdraw from a TFSA, whether for retirement or other purposes, that money remains tax-free and unrestricted. The TFSA can serve as both an emergency fund and a retirement income vehicle, making it an ideal destination for income tax refunds.