…And why a refund isn’t a good thing in the first place
If you filed a tax return in April, by now, you’ll have received a Notice of Assessment from the Canada Revenue Agency. Sometimes it’s accompanied by a tax refund cheque. If it’s substantial, it might even feel like you’ve won a small lottery. And all you have to do is decide how to spend it. Sorry to rain on your parade, but in fact, it’s no such thing. And a large-ish regular refund is usually a sign of poor planning.
Most people think of a tax refund as a “gift” of some sort. But the feds aren’t “giving” you anything. A tax refund simply means you’ve paid too much tax through the year. The government is happy about this, because it’s had the (interest-free) use of that extra money while you haven’t.
If your refund is in the hundreds or thousands of dollars, you have some cause for concern. That money could have been earning a decent investment return instead of sitting in the government’s general revenue slush fund.
If you’ve got it, invest it
So when you get that tax refund, and if it’s more than a few dollars, consider what you might do with it to recoup your loss of investment earnings on that money. Your best bet might be to reinvest 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 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.
Add to your Registered Retirement Savings Plan. Use your tax refund to top up your RRSP contribution. You’ll generate a tax deduction for this year (consider it a reward for letting the feds use your money tax-free in the previous year) and tax on any growth on investments in the RRSP is deferred until you collapse the plan, presumably many years from now at retirement.
A tax refund is a mistake…yours
As I said, getting a regular annual tax refund, especially a large one is often a sign of poor tax planning. For most taxpayers it means 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 simply 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. That should result in lower withholding from your paycheque.
Include regular deductions and non-refundable credits
However, Form TD1 does not include deductions or non-refundable tax credits such as contributions to an RRSP, childcare or employment expenses, and charitable donations. These can used to further cut withholding at source, by filing Form T1213 – Request to Reduce Tax Deductions at Source with the CRA. If approved, you’ll get a Letter of Authority from the CRA, which you’ll give to your employer, who will make the necessary adjustments to your source withholding tax.
Then, with any luck, on next year’s tax return you’ll have a zero balance in the refund or the amount owing box. Now that’s good planning!
© 2014 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited.