With tax season behind us, many people are anxiously awaiting their tax refund cheque in the mail. While this extra “bonus” may seem like a good excuse to splurge or go shopping, doing so can have disastrous consequences to your financial future.
First, it’s important to understand where the tax refund comes from. Let’s look at someone who earns $40,000 per year and works as an employee for a company. When they get their paycheque every two weeks, their employer automatically deducts a portion for income taxes. With everything else being equal, this tax deduction should be close to the amount that you will actually owe at the end of the year. If you have no income from other sources or no other deductions from allowable expenses, your tax return should be near even – nothing owed and no return. The refund for most is due to the fact that throughout the year, they make contributions to their company pensions and/or individual RRSPs. If the same person from above makes $8,000 of RRSP contributions that year, they will get a refund on the taxes they’ve previously paid on that income. For example, if they’re in a 30% tax bracket, they would get a refund for 30% of the $8,000 – or $2,400.
Here’s where many people make the mistake. If you were to take the $2,400 and go shopping or take a big trip, you’re missing the whole point of the RRSP program. Down the road in your retirement years, each and every dollar that comes out of your RRSP is considered taxable income. That means that any money you put into your RRSP now, and gain a tax credit for, will be taxed (along with the interest earned) as income when you withdraw it in your retirement. With that in mind, there are two main reasons the RRSP program works:
- The money inside your RRSP grows “tax-deferred” – By not paying taxes on your earned interest and growth each year, it compounds much more quickly.
- When you receive your tax refund each year that is due to your RRSP contributions, you take that refund and reinvest it back into your RRSP. This again multiplies the rate at which the account will compound and grow.
There has been much written on why RRSPs aren’t always the right choice and that using a Tax Free Savings Account or other investment vehicle is a better choice for you. For some people, I’d agree that this advice makes sense as this program isn’t a one-stop solution. For most others however, this advice may not be providing the whole story. The reality is that the RRSPs work and are an excellent tool for at least part of your retirement resources. It’s important to sit down with your financial advisor and figure out what plan(s) make the most sense for you.
So remember – When that tax refund cheque shows up in the mail this May, take the time to think about your options and make the right choice. In order to take advantage of the RRSP program and ensure that it works properly for you, make sure you review your options before cashing that cheque and heading to the mall.