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Make the most of your income tax refund this year

It's often been said that, next to being shot at and missed, there's nothing quite as satisfying as a tax refund. And we Canadians love our tax refunds. The average refund to date for the 2002 tax year is $1,102.69, according to the Canada Customs and Revenue Agency, which is just about exactly what I expect as a refund this year.

Interestingly, the new carpet that my wife, Carolyn, wants to place in the front hall is $1,092.50. This will leave me with $10.19.

The burning question? What should I do with that $10.19? More importantly, what should you do with the refund you're expecting this year?

Pay down debt.

This can be a great use of your tax refund.

Now, there's good debt and bad debt. Bad debt has a very high rate of interest and is generally used for personal consumption or to buy assets that are depreciating in value, where the interest costs are not deductible for tax purposes.

Credit card debt is a good example of bad debt. One big benefit to paying down debt is that it provides a decent guaranteed after-tax return on the investment of that tax refund. For example, if you have a $4,000 refund to utilize, and you pay down bad debt that is accruing interest at, say, 8 per cent, that equates to a guaranteed 8-per-cent after-tax rate of return on that $4,000. Not too shabby.

Invest the refund.

Another option is to take the tax refund and reinvest those dollars. It's amazing how much this can boost your retirement nest egg over the years. I won't debate whether you should invest the money inside or outside your registered retirement savings plan.

I will say this, however: If you contributed to your RRSP for 2002 because it was best for you at the time, then investing the tax savings inside your RRSP if you've got the contribution room likely makes the most sense.

Save for an education.

Have you got a child or grandchild in your life? It's tough to argue against the benefit of using your tax refund to save for that child's education.

I've done the math. If you start saving for a child's education in his or her first year, setting aside $2,000 annually will provide pretty close to what that child will need for a postsecondary education.

Now consider this: If you had made a deductible $5,000 RRSP contribution for 2002, you can expect about $2,300 in tax savings if you're in the highest tax bracket (likely coming back as a refund), and $2,000 of that could be contributed to a registered education savings plan for that child in your life. An eligible child will receive $400 in grants from the government on a $2,000 contribution. What a great way to use tax savings to generate even more money back from the government.

Service an investment loan.

Here's an idea that can really boost the value of your retirement savings. Where you're a good candidate to borrow to invest, consider using your tax refund to cover the interest costs on an interest-only investment loan. For example, a $3,500 tax refund would be sufficient to cover the after-tax interest costs on a $76,900 interest-only loan at 7 per cent ($76,900 times 7 per cent equals $5,383 in deductible interest equals $3,500 in interest costs after taxes if you're in the middle tax bracket and have a 35-per-cent marginal tax rate). This strategy is not for everyone, but it can effectively put your tax refund on steroids by getting more money working for you.

Give to charity.

Improving your own standard of living through the tax refund you receive makes sense, and no one will fault you for that. But why not consider making life a little better for others as well?

You can do this by committing all or a portion of your refund to charity. If every Canadian who had made an RRSP contribution in 1999 had committed one-half of the tax savings to charity, this would have provided an additional $4.65-billion to charities in Canada. Not bad when you consider that the total donated by Canadians to charities in 1999 was $4.79-billion.

Think of it. As Canadians, we could nearly double the assistance we provide to others by simply donating one half of our RRSP deduction tax savings (which typically comes back as a refund this time of year) to charity.

And don't forget, the taxman will provide even more tax savings when you make a donation, amounting on average to about 40 cents for each dollar donated, so your out-of-pocket cost will be even less than you think.

The bottom line

Which of these uses of your tax refund is best? In my book The Tax Freedom Zone, I make the case that the answer will depend largely on whether you have bad debt, the sufficiency and stability of your income, and the strength of your current retirement nest egg. If you're having trouble deciding how to handle those dollars, you may want to visit a trusted adviser.

Tim Cestnick, CA, CFP, TEP is author of The Tax Freedom Zone and Winning the Tax Game 2003. He is managing director, National Tax Services, at AIC Ltd.

tcestnick@aic.com



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