This year, I'm expecting a tax refund of $1,208.48. It hasn't arrived yet, but when it does, I've got an important decision to make: What to do with all that cash?
Well, Carolyn has earmarked $1,198 of it for some drapery she's had her eye on. So, in fact, I have to decide what to do with the remaining $10.48. I wouldn't say I'm losing sleep over this. But what about you? Are you expecting a tax refund? Perhaps you've received it already.
Let me share with you some ideas for that refund. You see, there are really just four options available to you. The right decision will depend on a few factors.
SPEND IT
There are fewer things that will be more enjoyable than spending that tax refund. So, you might want to splurge and treat yourself to that new lava lamp, solar-powered barbecue, or that MP3 player-pillow you've been admiring. Spending your entire refund makes sense only when your retirement savings are well under control, and you've got little or no "bad debt," which I'll talk about next.
PAY DOWN DEBT
Now, it's never a bad idea to use excess cash to pay down debt. Particularly bad debt. Bad debt has three characteristics: The interest rate is high (consider your credit cards), you've used the debt for personal consumption or to acquire depreciating assets (as opposed to assets that will grow in value over time), and your interest cannot be deducted for tax purposes. If you pay down your bad debt, this will provide you with a guaranteed rate of return equal to your after-tax interest cost.
For example, suppose your tax refund is $5,000. If you have bad debt on which you're paying non-deductible interest of, say, 5 per cent, then paying down that debt will provide a guaranteed after-tax return of 5 per cent. What rate of return would you have to achieve on your portfolio to end up with 5 per cent after taxes? You'd likely need a pre-tax return between 6.5 and 9.3 per cent to be left with 5 per cent after tax, depending on the makeup of your portfolio. And those returns are hardly guaranteed, as would be the case by paying down your debt.
Now, for a word about good debt. If you've got debt that is subject to a very low rate of interest, was used to acquire an appreciating asset (your home, for example), and where the interest is deductible (student loan interest, for example), then the urgency to pay down that debt isn't as great. In fact, if your debt has all three of these positive characteristics, I would go so far as to say that you should consider leaving that debt intact, as long as you have a stable income, and consider investing your tax refund instead.
INVEST IT
Although paying down your debt is never a bad idea, investing your refund will make sense if you're behind in saving for retirement. Contributing your refund to your registered retirement savings plan (RRSP) will give rise to additional tax savings from an RRSP deduction in 2010. If your refund is $5,000, contributing that cash to your RRSP will create additional tax savings - and potentially a refund next year - of between $1,250 and $2,300 depending on which province you live in and your level of income.
And let's not forget about saving for your child's education. While your own retirement savings should take priority over your child's education fund, contributing your tax refund to a registered education savings plan (RESP) will go a long way toward helping pay for that education. If you factor in the potential Canada Education Savings Grants on a $5,000 RESP contribution, those funds could grow over a 10-year period to be worth $12,950 at a rate of 8 per cent. That will help defray the cost of a year of education quite nicely.
GIVE IT AWAY
Here's your final option for your tax refund: Make a donation to help others. I'm thinking particularly of making a charitable donation to a registered charity of your choice. You see, a portion of your money is earmarked to help society, whether you like it or not. If you don't give voluntarily, you'll give involuntarily through our tax system. So why not self-direct this social capital? Your tax refund presents an opportunity to help others, and to gain some tax relief at the same time. For every dollar you give away, you can expect to receive about 40 cents to 46 cents back in tax savings. Not a bad deal.
Tim Cestnick