The tax refund trap
If you are saving with an RRSP, what you do with your tax refund matters—a lot.
Who hasn’t taken their RRSP tax rebate and blown it on something fun? Some have spent their rebates before they even get in their hands.
Admit it, we’ve all been there.
In my early 20s I was entitled to an annual tax refund on my part-time income because I was enrolled as a full-time university student. I’d file early every year and wait giddily for the taxman to send my juicy tax refund only to squander it on a new pair of designer jeans and a night on the town with my best girlfriends. “Free money” we used to call it.
Financial author and educator Talbot Stevens says this flawed assumption is all too common.
“People need to realize that if they are using RRSPs and spend the refund, they are converting after-tax dollars to before-tax dollars and that has a huge impact on what their RRSP will produce in terms of income at retirement.”
Some simple math illustrates his point: Say someone in the 40% tax bracket invests $3,000 in an RRSP and spends the $1,200 refund. By spending the rebate, that person is not contributing $3,000 towards their future, but only $1,800. When reinvested, a $3,000 contribution can equal nearly $5,000 before tax.
Still, some might be tempted to use their refund to pay down debt. Unfortunately, Stevens admits, there’s no consensus on whether it’s better to pay down a mortgage for instance or invest in an RRSP.
This is where a financial road map comes in handy. A fee-only planner can help you determine the best strategy to achieve your money-related goals. Re-visiting the plan every year will help you stay on track.
Paying down credit card debt however is a no-brainer. With interest rates on credit card balances averaging 19%, Stevens says this clearly has to be the top priority.
I stopped throwing away my tax refunds years ago—not because I wanted to, mind you.
In my final year of studies, my dad got smart and starting claiming the tuition-related tax deduction on his own filings to lower his overall tax bill. He was, after all, paying my tuition out-of-pocket. Lesson learned.
This year, my plan is to reinvest about half of my expected refund and toss the rest into my “fun fund.” I may be creeping closer to 30, but I’m still a work hard, play hard type of girl—only now my lifestyle goals go beyond clothing and clubs.
A 50-50 split between saving and splurging is not all bad and a lot better than most people, Stevens tells me.
“Do whatever you think maximizes your quality of life with your refund,” he says. “My message is to help people understand that if you are going to use RRSPs, you really need to be careful with what happens to the refund.”
I don’t regret spending part of my last refund on a dream vacation to the rainforests of St. Lucia. I’ve learned that with a little planning, there’s a greater chance I’ll be able to do more of the things I enjoy in the future.