Tax season is finally over and May is the month that brings tax refund cheques to many Canadians. However, anyone have put any thoughts about what to do with this tax refund? Let’s think about how to invest that money to make the most impact for this year and next year. We provide four great options to think about:
1. Roll the savings right back into your RRSP for the current year to improve your refund for the current tax year. The RRSP remains a tremendous savings vehicle, particularly for high income employees’ vs business owners. The theory is that you get to contribute pre-tax dollars and that it can grow in a tax differed environment until needed for retirement. This is one of the few options many high income earners have to protect some of their savings from the long reach of CRA and provide a nest egg for retirement. It does come with some downsides though. The RRSP doesn’t distinguish between types of income. Certain types of income generate better tax consequences than others, capital gains are only taxed at 50% of regular rates and Canadian dividends are currently taxed at rates that peak at 39.34% if eligible and 45.30% if non-eligible. Money withdrawn from an RRSP does not distinguish these “better” types of income and as a result all income generated within an RRSP is taxed the same. In practice we often see large estates that didn’t manage down the RRSP before the senior’s death and a significant tax liability is left. These are often best used by high income earners but should come with a drawdown plan as we age.
2. Contribute to a tax free savings account TFSA. The TFSA represented a significant departure in financial planning for Canadians and is still underutilized by many. This is often one of the best repositories for short term savings as well as a portion of your long term portfolio. Unlike the RRSP these contributions are from after tax dollars but all income, no matter what type is completely tax free to the holder. You can dip into the TFSA at anytime with no tax consequences but there are limits on when and how much you can recontribute after you have made withdrawals. In retirement the TFSA can provide a much needed income boost if there is a significant cash need in a given year without impacting many income-tested credits or old age security (OAS) claw backs as the withdrawals are not taxable. Lump sums taken from an RRS can impact not only the marginal tax rate that applies but the claw back of OAS and other credits. Everyone over the age of 18 should have a TFSA, even if it only houses some emergency savings account. In practice you can invest in a wide range of investment assets to meet your savings needs.
3. For those with children, the Registered Education Savings Plan (RESP) is great place to start. A $2,500 contribution for each child will generate a government grant of $500 to add to the account which can be invested for the child’s education. The funds can be invested in a wide range of products and the income that the capital contributed generates is taxable to the child when it is withdrawn for education. The list of post secondary educational programs that qualifies is exhaustive. If not used for education you can always take the capital and accumulated income back into your RRSP, but you will have to repay the grants.
4. Put the savings down against your mortgage. Whether by lump sum payment or increasing your biweekly payments amount, this is always a good way to pay down your mortgage faster. Even though interest rates are at historical lows having a home paid for provides tremendous piece of mind and reduces the future financial pressure. Even if you are paying down a 3% mortgage with the savings it is still a great rate of return as you are effectively achieving a guaranteed 3% after tax rate of return. In the top tax bracket you would have to have a pre tax rate of return of almost 6.4% to achieve the same impact. I challenge anyone to find that guaranteed rate anywhere.
No matter how you decide to invest your savings we wish to encourage you to have the conversation with your tax advisor as to how to best achieve your financial goals. Tax and financial planning is best done throughout the year with your objectives in mind. We invite you to engage us in that conversation.