Why Tax Refunds are a Bad Thing (and How You Can Avoid Them)
There are many jokes about how terrible tax time is, but the truth is that many people actually enjoy tax time. While the paperwork is never a good time, the result of filing your taxes can mean that you end up with a nice, big refund.
However, getting a big refund isn’t always the best way to go about things. The truth is this: while many people get excited about large tax refunds, all it really means is that you lent the government money throughout the year, interest-free.
Use Your Money for You, All Year Long
Many people think of a tax refund as a windfall. It feels as though you are getting “new” money. However, there’s a reason that it’s called a refund. Basically, the government owes you money because you have overpaid in taxes.
When you have a tax refund coming, especially a big one, it means that you have been sending money to the government, for the government to use without paying you interest. Rather than letting the government use that money, you could be putting it to work on your own behalf. You could be using that money all year to improve your financial situation. You could be earning interest on that money.
Say you are paid bi-weekly and every year you expect a tax refund of $5,200. Maybe this is due to set RRSP contributions, plus a stay at home spouse and a couple of children. While it is nice to get all this money at once and make a lump sum mortgage payment, pay down consumer debt or put it in savings and investments, you lose out a bit by not having that extra $200 every two weeks. Yes, you get it back in the end, but there are other things you could be doing with the money throughout the year, to see a much better result.
With mortgages or other debt, paying an extra $200 every two weeks will reduce your principal sooner so you pay less interest overall. Not only can you pay less in interest, but you will pay off your mortgage faster. It’s a good way to truly become debt free, and do it faster than you would with a single payment once a year.
You don’t have to use your money to pay down a mortgage, though. You can also benefit with the help of savings. Instead of using the lump sum, and put money in every two weeks to give it extra time for the interest to grow. The extra interest can give you a boost since the compound interest will increase your bank account faster than if you wait to receive a tax refund.
You can do even better over time if you invest that money every two weeks, instead of at refund time. You’ll get the benefits of dollar cost averaging, catching both the highs and lows to reduce your risk.
Adjusting Your Tax Withholding
If you want to change things up, and make sure that you are growing your wealth faster, you need to change your tax withholding. Once you get your withholding adjusted, you can keep more money in your pay cheque, and use it to improve your finances.
The first form you can complete is the TD1. Filing this form with your employer will allow them to adjust the amount of tax they deduct from your income for the following items:
- Child amount
- Age amount
- Pension income amount
- Tuition, education and textbook amounts
- Disability amount
- Spouse or common-law partner amount
- Amount for an eligible dependant
- Caregiver amount
- Amount for infirm dependants age 18 or older
- Amounts transferred from your spouse or common-law partner
- Amounts transferred from a dependant
The second form that can help is the T1213. This form needs to be submitted to the Client Services Division of your tax services office. They will then send you a letter of authority to give to your employer. This will instruct your employer to deduct less tax from your income due to the following deductions or tax credits:
- RRSP contributions
- Child care expenses
- Support payments
- Employment expenses
- Carrying charges and interest expenses on investment loans
- Charitable donations
- Political contributions
While it does take a little extra effort to change your withholding, it’s worth it. Long term, it means that you have better opportunities to boost your wealth over time.