Doing one's taxes is an annual chore akin to going to the dentist. Even when we expect our tax return to bring a refund, we all dread the end of April when our taxes are due. The increasingly complex financial situations we find ourselves involved in make each year's return seem more painstaking than the last.
Many personal finance experts recommend reducing your tax deductions at the source, so that less tax is taken off your paycheck every two weeks, allowing you to put the money to use immediately. By doing this, you might not get a refund check when filing your taxes. But you also won't be lending your money to the federal government at 0% interest for a good portion of the year.
However, for those who aren't good at saving money, and are like so many who wait for their refund in the spring, it's important that you have a plan to use the money in a sensible manner. It's too easy to just spend it on fancy electronics or European vacations.
With that in mind, we've come up with five options for your refund check that will ensure your future financial well-being.
1. Pay Down Debt
Although there are various kinds of debt, the most important to eliminate before you do anything else is your high-interest credit card debt. The typical bank credit card charges around 20% for unpaid balances. When you don't pay your balance in full, you're using the power of compound interest against you. The interest charges are tacked on to the balance, so the next month's interest charges are even greater - despite the fact you didn't make any additional purchases. In investing terms, if you have $10,000 in credit card debt and pay annual interest of $2,000, you'll need an annual return of 20% just to break even. Given the S&P/TSX Index historically has averaged an annual total return of 6.8%, it's much wiser to pay down your debt before doing anything else.
2. Fund Your Emergency Savings
Once you've paid off all your high-interest debt, you'll want to create an emergency savings account that covers any unexpected life situations that may crop up, such as losing your job or an extended illness. Experts suggest that an emergency fund should have between three and six months' salary stashed away to cover essential expenses including rent or mortgage payments, groceries, utilities and insurance. Putting aside this money for a rainy day ensures you don't have to borrow from your line of credit, or worse still, your high-interest credit card. Either open a high-interest savings account to hold your emergency funds, or even better, create a Tax-Free Savings Account (TFSA) to save your money tax free.
3. Save for Retirement
Now that you've managed to eliminate all your debt except your mortgage, it's time to put something away for your retirement. Whether you're 25 or 55, it's always a good idea to be putting something away for those years when you're no longer working. Canadians have two basic investment vehicles to save for retirement; an RRSP or TFSA – and both have their own disadvantages.
- The Registered Retirement Savings Plan (RRSP) allows you to make contributions tax-deductible up to a certain limit, which reduces the amount of tax paid and grows tax-free until withdrawn at retirement. Any funds withdrawn from an RRSP are treated as regular income and taxed at the corresponding tax rate. It's a smart way to defer taxes while saving for retirement.
- A relatively recent addition to the retirement savings effort by the federal government is the TFSA, introduced in 2009. The TFSA allows Canadians to save additional funds for retirement. Unlike the RRSP, which allows tax-deductible contributions, the TFSA uses after-tax dollars (no tax deductibility) to build savings. While the annual limits allowed are generally lower than the RRSP, the funds grow tax-free inside the TFSA, just like the RRSP. Even more importantly, when withdrawn no taxes are payable, unlike the RRSP. It's an important piece of anyone's savings.
For Canadians who've yet to buy their own home, the federal government has a very helpful program that works hand-in-hand with the RRSP. It's called the Home Buyers' Plan (HBP), and it allows an individual taxpayer to withdraw funds (up to a certain dollar limit) from the RRSP for the purchase of a home. The home must be considered a first-time home purchase, and the withdrawals must be repaid to your RRSP within 15 years. While some repay the funds using equal installments over those 15 years, it's perfectly acceptable to repay all of the funds borrowed at any time prior to the end of the 15-year limit.
For those of you who own a home already, the faster you can repay your mortgage, the sooner you'll be debt-free and moving toward financial independence.
5. Start a College Savings Fund
The other major financial commitment for most Canadians is paying for their children's post-secondary education. Whether heading to a university or community college, education is an expensive proposition. The federal government provides an education savings plan called the Registered Education Savings Plan (RESP), which allows parents to contribute a maximum amount per beneficiary over a lifetime. The federal government kicks in additional grant money over the lifetime of the beneficiary. While the contributions to the RESP aren't tax deductible, the assets held within the plan grow tax-free until they are withdrawn to pay for the child's education. Because the withdrawals are taxed in the hands of the student, there are little or no taxes paid.
The Bottom Line
While none of these options is as interesting as living the high life, they go a long way to ensuring you and your family are financially independent throughout your lives.
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