Tax refunds: Splurge vs save?

For many Canadians, tax season means a lump sum of money: according to the Canada Revenue Agency, the average refund in 2011 was $1,580.

“Many Canadians think of a tax refund as a bonus, even though it’s your own money to begin with,” says Cynthia Caskey, vice president, sales manager & portfolio manager, TD Wealth Private Investment Advice.

“It can be tempting to splurge on luxury items, but many Canadians need to balance paying debt, saving for a child’s education, and for retirement. It’s important to consider these needs when deciding how best to spend your refund.”

For clients who are eager to spend their refunds, Caskey offers the following suggestions:

> Pay down high-interest debt
This can include outstanding credit card balances, and should be your top priority. Consider making a lump-sum payment, especially if the interest on the debt is not tax deductible.

> Save for a child’s education
Contribute to a child’s Registered Education Savings Plan (RESP), which will also potentially qualify them for a Canada Education Savings Grant (CESG). The plan will earn tax-free investment income on both the contribution and any government grants. Grandparents may consider opening a family RESP plan, which can have multiple children as beneficiaries.

> Create a flexible savings strategy
A contribution to a Tax-Free Savings Account (TFSA) can be part of a client’s retirement savings strategy, and interest earned and investment income is not taxed. Because the account holder can withdraw the funds at any time, it is a great option for use as an emergency fund. A good rule of thumb is to have at least six months of living expenses set aside for contingencies.

For clients hoping to reduce taxes owed next year, Caskey offers the following tips:

> Take a year-round approach to tax savings Reviewing your clients’ asset allocation with throughout the year may help ensure investments are allocated to maximize tax efficiency. Ask clients to consider contributing to RRSPs regularly throughout the year, instead of making a lump-sum contribution, to take advantage of compound interest.

> Invest efficiently outside RRSPs/TFSAs
Determine an appropriate asset mix and consider investment solutions based on their tax efficiency. For example, Return of Capital distributions may be received tax-free, but they reduce the adjusted cost base of the investment. Also keep in mind that capital gains are taxed at half the rate of interest income.

> Plan not to get a tax refund in the first place
A large tax refund that mean a client is overpaying. Ask the client to consider making regular contributions to an RRSP, and discuss strategies to ensure you’re being tax efficient.