How to make your tax refund pay long-term dividends
If you're expecting a refund, tax season can feel like Christmas. You file your wish list of a tax return and count the sleeps until the day Canada Revenue Agency drops a cheque into the mailbox you’ve hung by the front door with care.
But as one business columnist noted, you’re really only getting back what was yours to begin with, and nothing more. It’s more like you’ve lent out a really useful book – on financial planning, let’s say – and got it back a year or so later. All the while, you could have really used it.
To make the most of that “gift,” we asked Finance instructor (and certified financial planner) Tannya McBride (Finance ’07) how to make the most of your money now that it’s back in your hands. A trip or pricey toy is OK if you’ve been a prudent, diligent investor all year. If you haven’t, here are five tax-smart ways to make up for lost time.
1. Tackle high-interest debt
Before doing anything else with your refund, pay off outstanding credit card balances, says McBride.
Address retail store cards first, as they tend to have higher rates, sometimes approaching 30%.
Consider calling the credit company before paying. Most people don’t know it, says McBride, but “interest rates are completely negotiable.”
2. Invest in an RRSP
Of all the investments you can make with your return, “RRSP would be most tax efficient,” says McBride.
Your refund will go toward lowering your taxes while funding your retirement. That’s because an RRSP is a tax shelter (until you make a withdrawal), she points out, which means that your refund has the potential to truly swell with compounding interest. These accounts house most types of investments.
3. Or go with a TFSA
Sometimes, an RRSP isn’t the answer. “If you’re in a lower tax bracket, a tax-free savings account [TFSA] definitely makes more sense,” says McBride.
In cases when there’s nowhere to go but up, the income reduction (and possible tax-bracket drop) that comes with investing in an RRSP won’t help to reduce your overall taxes. Instead, grow your refund in a TFSA until you move up a bracket and there’s real benefit in lowering your income.
Then transfer the funds into an RRSP.
Those who expect to be in a higher tax bracket at retirement might also consider a TFSA. Once you begin withdrawing from an RRSP, it’s taxable income, which means you could give up a chunk of what you scrimped and saved.
What’s more, if you’re “earning” too much from your retirement savings, you could be susceptible to “clawbacks,” such as decreased Old Age Security.
If you’re not sure where you stand, ask a planner to crunch the numbers for you.
Lower risk, higher tax
Savings accounts, guaranteed investment certificates, bonds and other investments that generate income as interest may be relatively safe bets but they’re not tax efficient.
They’re treated like income, which means that 100% (as compared to 50% for capital gains) is taxable. From the perspective of tax-smart investing, “interest income is definitely the worst,” says McBride.
4. Buy stocks without dividends
Not all stocks pay dividends. That can be good for your future tax returns because, until you actually sell, “you don’t have to report anything,” says McBride.
When you do, she adds, those capital gains you report are the most tax-efficient type of investment income. Only 50% of them must be claimed.
5. Try mutual funds – but not just any mutual funds
For high-income earners who expect to be in a lower tax bracket in the future, corporate class mutual funds save the trouble that conventional mutual funds deliver annually: corporate class earnings aren’t taxed until the investment is sold.
At that point, a lower tax bracket will mean less tax paid overall.
These funds are held within a corporation that pools the income they earn year after year. The companies do pay dividends out of their corporate profits – that’s where the catch comes in. Those payouts are treated as if they’re your initial investment money being returned to you, which has the effect of increasing taxable capital gains when you sell.
For example, if you started with a $10,000 investment, $2,000 in dividends – or, your money paid pack – would reduce your upfront cost to $8,000. If your fund units are worth $15,000 when you sell, you pay capital gains on $7,000 rather than just $5,000.
That said, you’d only have to pay tax on $3,500 (or 50%) of those capital gains, making corporate class mutual funds a good way to turn your tax refund into a gift that keeps on giving.