Although not everyone gets a tax refund from their tax return every year, those who do get one may be wondering what’s the best way to use it. We’ll help you with some useful insights and ideas, but first you need to understand how tax refunds work.
How Tax Refunds Work
It’s important to realize that in order to receive a tax refund, you have to first pay taxes. It’s also important to recognize that not everyone is entitled to a tax refund.
Every time you get paid by your employer, they keep a portion to remit to the Canada Revenue Agency (CRA). This includes your share of CPP and EI, and the income tax you owe, and is sent to the CRA by your employer. At the end of the year, you have to file a tax return. The tax return calculates what you actually owe for the year and subtracts the tax you already paid. If you paid more than you owe, you get a tax refund. If you paid less than you owe, you have to pay the difference.
Tax Credits and Benefits
There are other programs and tax credits that are available when you file your taxes. This may result in other payments that are sent quarterly or monthly. Some examples are the Canada Child Benefit, GST/HST credit and the Climate Action Incentive Payment.
If you have a tax refund, please read on for great tips and hacks on how to get the most out of it.
Your Tax Refund Strategy
Although it might be fun to spend your tax refund on something that provides immediate gratification, it might not be the best thing to do strategically. This post will cover some basic strategic moves you can make to have a brighter financial future.
Pay Down High-Interest Debt
One of the biggest drains on Canadian personal finances is debt. Using your tax refund to pay down high-interest debt, like from a credit card, is one of the wisest moves you can make. This is our most recommended course of action, especially if you have a balance on your credit card.
This doesn’t mean you should pay off all debt before considering something else. Low interest debt can be used to further your financial goals or fund lifestyle. Most people can’t afford to pay off their entire mortgage before doing anything else.
The key with this strategy is to lower your weighted average interest rate by reducing the high-interest debt. In a nutshell, pay down the debt that has the highest interest, and you’ll reduce the amount of interest you’re paying. That will free up cash for other things.
Contribute to Your RRSP
Contributing to your current year’s RRSP can have terrific benefits. It can reduce your taxes payable for the current year, which can possibly increase your next income tax refund or reduce your next balance owing. Also, the earnings within your RRSP are tax deferred, meaning you don’t pay tax on them right away. You don’t have to pay tax until you start withdrawing from your RRSP. This also helps secure your financial future.
Consider your income for the current year before making the contribution. If you don’t have income (you won’t pay tax), there is no immediate benefit to contributing to your RRSP. Also, some individuals may be better off to save and invest in different manners. If you expect income from other sources when you retire, your TFSA might be a better vehicle to use. Subtle differences in situations can have a big impact, so if you aren’t sure, consult a professional.
Build Your TFSA
Tax Free Savings Accounts (TFSAs) are a fantastic place to invest. You can contribute a set amount per year, $6,000 for 2022. However, this amount grows every year. If you’ve never contributed to your TFSA, you could have a lot of contribution room accumulated.
Money you invest in your TFSA can be withdrawn and used for whatever you want. When you withdraw in one year, you can put the amount back in the following calendar year. The best part about the TFSA is that income earned in this vehicle is not taxable. Every year, we see people being taxed on investment income while they have unused TFSA contributions. By building this up before using unregistered investment vehicles (neither TFSA nor RRSP), you are being more tax-efficient.
Ideally, the TFSA is part of your long-term financial planning, not a savings account for the next vacation or big purchase. If the money in your TFSA is sitting in cash, it is losing real purchasing power. It’s very important to get good advice and invest within the TFSA.
Plan Your Family’s Financial Future
Another thing families need to think about is their own future and their childrens’ futures.
If a member of your family has a disability, consider the Registered Disability Savings Plan (RDSP). This program may also be eligible for grants and bonds from the government to help provide financial security for the beneficiary. Eligibility for these depends on your family income and the amount of contributions made.
Contributions to an RDSP do not decrease your income like an RRSP does. However, when the funds are withdrawn, the contribution amounts are not taxable, only the income earned. Tax is paid when the contributions are made, and tax must be paid on the investment income and added contributions by the government when withdrawn.
You may also consider the Registered Education Savings Plan (RESP) for your children. Similar to an RDSP, earnings in this program are tax deferred and contributions can be returned tax-free. There are also matching programs similar to an RDSP that depend on family income. When the funds are withdrawn, they must be used for specific educational purposes.
More Tax Refund Ideas
There might be some other things you want to do with your refund. Here are some ideas that also have tax benefits:
- Political donations to registered parties (tax deductible)
- Donations to registered charities (tax deductible)
- Vacations eligible for Staycation Tax Credits
Be sure to check with your province of residency to see if you qualify for any staycation tax credit in your province. Not all provinces have them. Generally, your vacation has to take place in that province to qualify. Ontario won’t give you a tax credit to vacation in Bermuda.
What’s Best for Your Tax Refund?
Everyone’s situation is different. It’s your money, it’s your financial future, it’s your right and your responsibility to know. If you need help deciding what to do, it might be a good time to seek professional advice.
Contact KATA Today for all your accounting and tax needs