May 5, 2023
Why re-investing your tax refund is the smart option
By Dale Jackson
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Personal Finance Columnist, Payback Time
The pause provides a great opportunity for Canadians who contributed to their registered retirement savings plans (RRSP) to reflect on how they are going to spend their refunds.
Many see it as a windfall - or fun money - and might not realize that the biggest advantage of an RRSP is lost unless the refund is re-invested.
RE-INVESTED REFUNDS COMPOUND RRSP SAVINGS
The RRSP is a great retirement saving tool because contributions and the tax savings they generate can grow in investments tax-free over a long period of time
If you are one of the many Canadians who scramble every February to make your RRSP contribution before the deadline, consider getting a jump on this year’s tax savings by re-contributing your refund.
In addition to taking some of the pressure off, re-investing your refund will generate another refund next year, and that re-invested refund will generate another refund - and so on.
Re-investing refunds can super-charge RRSP savings over the years but it’s important to keep in mind that all those contributions, and all the returns they generate will eventually be taxed when they are withdrawn.
The trick is to make RRSP contributions when you are paying tax at a high marginal rate and withdraw when you are at a low marginal rate - ideally, in retirement.
If RRSP savings grow too much you will eventually be forced to make minimal withdrawals at a higher rate, and benefits such as Old Age Security (OAS) could be clawed back.
DIVERT YOUR REFUND TO A TFSA
If you are concerned your RRSP is growing too much or if you currently pay tax at a low marginal rate (because your income is low), consider re-investing your RRSP refund in a tax-free savings account (TFSA).
Unlike an RRSP, TFSA contributions can not be deducted from taxable income. On the bright side, TFSA withdrawals are never taxed. Like an RRSP, they can hold just about any investments.
Ideally, the right mix of savings in an RRSP and TFSA will allow you to withdraw from your RRSP at the lowest marginal rate in retirement and top-off any further living expenses from your TFSA.
As of January 1, Ottawa has permitted another $6,500 in TFSA contribution space for 2023. For anyone who was 18 or older when the TFSA was launched in 2009 the total contribution limit is $88,000.
The federal government is expected to continue adding TFSA contribution space in future years, which means it could become a permanent home for your RRSP refunds.
PAY DOWN DEBT
The rapid rise in borrowing rates over the past year has made paying down debt even more important and a better investment for your RRSP refund.
Each dollar invested in paying down debt generates a risk-free, tax-free, return equal to the interest rate being charged.
Choosing to invest your tax refund in credit card debt, which can be in the 20 per cent range, is a no brainer. So is student or consumer debt, which charges rates at over 10 per cent.
The only debt that might get a pass is mortgage debt because it is normally lower. The interest rate on five-year fixed mortgages is currently in the low five per cent range but does not have the same tax advantages as RRSPs.
Guaranteed investment certificates (GICs), for example, are comparable investments with comparable yields but will generate a refund in an RRSP.Either way, your tax refund is invested in your future.