How to spend your tax refund

The Tax Blog for Smart Canadians

Tips and tricks for Canadian tax filers at every stage of life from UFile's tax expert Gerry Vittoratos

How to spend your tax refund

by UFile Team Équipe ImpôtExpert | May 13, 2020   Comments:

UFile blog - How to spend your refund

The best part of filing your tax return is (hopefully) getting a refund. You’ve earned it! Now, what should you do with the cash? Let’s find out.

Pay off your debts

This doesn’t sound as exciting as using the money to go on a vacation, but paying off your debts should be at the top of the list.

What debt should you focus on first? You could go with the debt avalanche method where you make the minimum required payments for each debt, then use the remainder to pay off the debt with the highest interest first, such as a credit card. This approach will save you the most money in the long term.

Another repayment method is the debt snowball. Again, you make the minimum required payments for all of your debts, then you pay off the debts with the smallest balance first, essentially closing those accounts faster. Choosing this method might not save you as much money as the debt avalanche method; however, studies have shown that you are more likely to stick to your repayment plan under this method since you get a bigger sense of accomplishment from closing off your debt accounts faster.  

Another consideration is whether your debt is linked to an asset. This is what is called a secured debt. Examples of this are car loans and mortgages. If you’re behind on your payments for these types of assets, your refund should go towards repaying these debts first. Although the interest rates on these loans are lower than for debts such as credit cards, you risk getting assets such as your home or your car repossessed by missing payments. That can be more costly than carrying a credit card debt.

You could invest your money in the stock market (see below), but remember that your return has to exceed the interest rate you are paying on these debts. As we all know, your returns in the stock market are never guaranteed; what is guaranteed, however, is the money that you are losing in interest on your loans. By paying down your loans, you have a guaranteed return on your investment, which is the interest you are saving.

Invest in the stock market through your RRSP/TFSA

Next on your list of priorities is to invest your refund in tax-sheltered accounts such as RRSPs or TFSAs. You should only do this if you have no high-interest debt left, and you can make the payments on your low-interest debt such as secured debts (see above) if any.

There are multiple advantages to contributing your refund to your RRSP or your TFSA. Let’s look at each account:

  • For RRSPs, you get a tax deduction for your contributions, and gains within the accounts are sheltered from taxation. You only pay tax when you withdraw from the account after you retire.
  • For TFSAs, you don’t get a tax deduction on your contributions, unfortunately; however, your gains within these accounts are sheltered from taxation, just like with an RRSP, and your withdrawals are entirely tax-free.

In the long term, the best investment you can make within these accounts is in the stock market. Don’t forget that one of the main advantages of investing in the stock market is the compounding effect. For example, if you make 5% on $1,000 one year, you have earned $50, and you have $1,050 dollars in your account at the end of the year. If you make another 5% in the same account the following year, you earn another $52.25 ($1,050 x 5%). Due to the compounding effect, you have earned an extra $2.25.

It might not seem like much in this simplistic example, but if you increase the number of years and the amount invested, your money can grow exponentially.

Once you have used your refund to pay off your debts and to maximize your RRSP/TFSA, you can spoil yourself with the remainder.

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