Why your tax refund may be a planning mistake
When you get a tax refund, it would be nice to think the government is “giving” you something. But that’s not the case. A large tax refund simply means you’ve paid too much tax through the year. You’re just getting your own money back. If you get a large refund regularly, it’s a sign you need to tighten up your tax planning. The government is happy about it, because it’s had the use of that extra money interest free, while you haven’t. That money could have been earning a decent investment return instead of sitting in the government’s general revenue slush fund.
For most taxpayers who are employed, a tax refund simply means that the tax-owing calculation on your General T1 Tax Return is less than the amount withheld at source by your employer.
Tax withholding at source is the amount of tax your employer has calculated should be withheld from your paycheque and remitted to the government based on Form TD1 – Personal Tax Credits, which you’ll have filled out on the first day of your employment. This includes such tax credits as the Basic Personal Amount, as well as such items as Child, Age, Tuition, Caregiver, Dependent amounts. If you’ve missed any of these (or added some since you joined your employer), you can make changes to these amounts by asking your employer for a new Form TD1 and adjusting the various credits and amounts accordingly. That should result in lower withholding from your paycheque.
Other culprits that could lead to a refund include RRSP contributions, spousal support payments, childcare expenses, and interest on loans made for investment or business reasons – these won’t necessarily be part of source withholding by your employer. If these are amounts you incur regularly, consider filing CRA Form T1213 – Request to Reduce Tax Deductions at Source. If approved by the CRA, you’ll receive a “Letter of Authority,” which will allow your employer to further cut the tax withheld on your paycheque.
Then, with any luck, on next year’s tax return you’ll have a zero balance in the refund or the amount owing box.
If you get a refund, use it!
If your tax refund is more than a few hundred dollars, consider reinvesting it in something that generates a return larger than the rate of inflation over the past year.
* Pay down high-interest consumer debt. With credit card interest typically starting at 25% annually, outstanding credit card balances are costing you a fortune in interest payments. Apply your tax refund to that balance and put that 25% annual interest back in your pocket.
* Pay down your mortgage. Add your tax refund to top up your annual mortgage prepayment to the maximum allowable if possible. The prepayment is applied directly to the principal, thus reducing the total interest payable over the life of the mortgage, while also reducing the amortization period.
* Contribute to a Tax-Free Savings Account. The TFSA is your best bet for creating immediate tax-free dollars. A TFSA is a government-registered account in which investments grow tax-free. You can apply your contribution to a wide variety of investments, including stocks, bonds, mutual funds, and exchange-traded funds. Withdrawals from the account are also completely tax-free.
You can contribute up to a maximum $5,500 to a TFSA in 2014, and carry forward unused contribution room from previous years. The contribution limit is not income-tested as it is for an RRSP, so anyone can contribute the maximum every year regardless of their income level. There’s no deduction for contributions, as there is for RRSPs, but that’s offset by the tax-free nature of income generated within the plan, as well as on withdrawals.
* Top up your Registered Retirement Savings Plan. You’ll generate a tax deduction for this year, while tax on any growth on investments in the RRSP is deferred until you collapse the plan, presumably many years from now at retirement.
© 2016 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited. This article is for information only and is not intended as personal investment or financial advice.