Ever wondered why you may receive a tax refund?
Why would someone give you money back?
It is because you’ve been a good boy or girl over the last year? No. Santa takes care of that anyhow.
It is because our government is flush with cash? No, hardly; we can barely afford to keep our education and healthcare system afloat.
To answer the question, it’s because you’ve overpaid on income taxes for that tax year. The government is actually paying you back the extra money you’ve paid them through miscalculated payroll deductions over the last calendar/tax year. In any given tax year (believe it or not) you only need to pay the amount of tax you owe for that tax year – no more, no less.
You’re getting money back since you’ve essentially given our government an interest-free loan.
Who loans money to the government interest-free? Many of us do.
When it comes to tax planning my advice is: don’t assume a big fat tax refund every year is good. If you’re always looking forward to the juicy refund it simply means the government kept some of your money and you could have had it working for you instead throughout the year.
Now that tax season is on the horizon, I figured it was a good time to reach out to Robin Taub, tax expert, writer, speaker and personal finance consultant to get her professional take on big tax refunds.
Robin, are big tax refunds a good thing?
“If you get a refund every year from the CRA, it’s actually not a cause for celebration. It may mean that too much tax is being withheld at source by your employer. Make sure you complete the TD1 Personal Tax Credits Return properly. And if your personal circumstances change, like you get married or have a baby, tell your employer and complete a new TD1 form, as you may be entitled to some new tax credits.”
From my perspective here are two things to consider this year to change what your tax refund might look like.
- Consider optimizing Registered Retirement Savings Plan (RRSP) contributions
You already know when you contribute to an RRSP your taxable income gets reduced – the RRSP is a tax deferred plan. So if you make $60,000 in income for that tax year and you contribute $5,000 to your RRSP during that year, you’re actually going to be taxed on only $55,000.
But just remember any RRSP-generated tax refund is really a government loan. Effectively you’re deferring taxes at the present day value only to pay taxes back in a future tax value yet to be determined. Your government-loan doesn’t last forever.
This is not to suggest RRSP contributions are a bad idea – they are a great idea. However, consider optimizing your RRSP contributions this year. This means you’re contributing just enough whereby you won’t pay any income tax in any given year. If that doesn’t jive with you and you’re determined to maximize contributions to your RRSP – by all means do that – just be sure you do not blow the juicy tax refund. Doing that is destroying the value of this account. It’s the linchpin in the RRSP vs. TFSA investing debate. I recall David Chilton said it best:
If you’re going to put money in a registered retirement savings plan and “blow the refund on something stupid,” then a major advantage of the RRSP – the immediate tax benefit – is lost.
The takeaway – don’t spend your RRSP refund. Consider reinvesting the money inside your RRSP, filling up your TFSA, putting money aside for your kid’s RESP, paying down debt or putting the money into an emergency fund (if you don’t already have one).
- Consider reducing your payroll taxes.
So you now know that huge tax refunds are not desirable and a tax expert said so – unless they relate to your RRSP contributions. Should anything else be done?
In conjunction with your monthly RRSP contributions consider reducing your payroll taxes at the source. Doing so will keep more money in your pocket throughout the year rather than waiting until spring the following year to get your money back via a tax refund.
How to do this?
- Complete CRA Form T1213, Request to Reduce Tax Deductions at Source.
- Make sure when you complete the form you indicate your annual RRSP contributions, and attach details about your preauthorized contributions.
- Sign and date the form and send it to your local tax centre as indicated on the form.
- Follow-up in about 2-3 weeks about the status of this form.
- Rinse and repeat each and every tax year.
You can also use this same form to highlight other tax deductions you expect to file in any given tax year but that might complicate matters – unless of course you know these deduction values and have intentions to accurately stick to them. You should receive a letter from CRA highlighting the information is on file and you can take this letter to your employer, who can then adjust your income tax deductions.
Here’s Robin’s professional take:
“If you know you’re going to have significant deductions in a given year, like RRSP contributions or child care expenses, complete and file Form T1213 Request to Reduce Tax Deductions at Source. Your employer will then make the appropriate adjustments to the tax withheld.”
If you’re considering this route Robin adds:
“Adjusting your tax withholdings could mean an increase in your net take-home pay all year-round, not just a lump sum at tax time. Try to make the most of that extra cash flow.”
What do I do? Do I expect a refund and if so, what do I do with it?
I haven’t filed Form T1213 and I admit I still look forward to an RRSP-generated tax refund every year but we almost always use the money to reinvest inside our RRSPs or pay down debt. In recent years a main money goal of ours is to maximize all contributions to our TFSAs early in the new year, so these are really the best remaining options for us.
At the end of the day any tax refund should not be considered a financial windfall – it’s your fair share of money owed to you. Either you decide to manage your taxes better throughout the year or manage it appropriately come tax filing time. Either way – just don’t blow the tax refund. Your future financial self will thank you. Thanks again to Robin for her insights. You can follow Robin on Twitter @robintaub.
What’s your take on tax refunds? Something you manage? Something you spend?