4 Ways to Use Your Income Tax Refund

Date posted: April 21, 2016
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Photo Credit: Images Money

With the average income tax refund in Canada hovering at $1,641, it’s easy to understand why many Canadians are tempted to spend this once-a-year windfall on travel or consumer goods. Heck, I’ve done that. When I turned 21, I spent my income-tax refund on a trip to Las Vegas! It was fun, but it wasn’t a good use of that money, especially since I was racking up over $38,000 in student loans at the same time.

There is a better way to use your tax refund: to achieve your financial goals. Here are four ways use this money that will better your financial situation.

Pay Down Debt

Personally, I’ve used my income tax refund to pay down debt twice. In 2011, I had $38,000 in student loan and car loan debt, and it felt like I’d never pay it all off. Fortunately, I received two large income tax refunds, and I used them to pay down large swaths of debt in one fell swoop.

Paying down debt is the best thing you can do with your income tax refund. If you choose to go this route, make sure to pay down your highest interest debt first, because that debt is costing you the most money on a day-to-day basis.

After you’ve made your big payment, make sure to recalculate your debt free date to see how much closer to debt freedom you are, which will reinforce that this was a good use of your money.

Start An Emergency Fund

Have you ever lived paycheque-to-paycheque and needed to charge even the smallest unexpected expense to a credit card? I have. But there is a way to avoid this situation entirely, to ensure you’re never caught without a cash cushion again, and that is to develop an emergency fund.

An emergency fund (or “rainy day fund” as some people call it) is there for you when unexpected expenses like car repairs pop up. Instead of putting those emergencies on your credit card, you pull from your cash cushion. An emergency fund helps you stay off the credit card debt treadmill and helps you avoid costly interest charges.

A healthy emergency fund should cover your minimum living expenses for three to six months. But if you are in the midst of paying down your debt, you probably don’t want to put that on hold for several months to build up your emergency fund. If this is the case for you, a smaller emergency fund of $1,000 - $2,000 is enough for a short-term cushion.

An income tax refund can be a great start to an emergency fund. With a $1,641 refund, you could rest easy knowing that you can pay off your consumer debt without worrying about an unexpected expense derailing your progress.

If you've paid off your debt, you should be saving three to six months of living expenses in your emergency fund, and your income tax refund will be a good start to this savings goal.

Save for A Big Purchase or Goal

An excellent way to get out of the habit of credit card debt is to start saving for your major goals in advance and paying for them with cash. That means instead of putting your vacation on your credit card and paying it off after (and possibly incurring interest charges along the way), you save for it leading up to the trip and pay up front.

Using your income tax refund to accomplish your savings goals is a great way to reinforce this healthy financial habit. I save for all of my purchases in advance. Saving in advance is a much healthier, less expensive and less stressful.

Here are some examples of purchases or goals you could try paying for in cash:

•    Vacations

•    Furniture

•    Renovations

•    Cars

Contribute To Your Registered Retirement Savings Plan (RRSP)

Ideally, you are already saving a small amount of your paycheque (between 10 – 15%) for retirement each and every pay period. But I understand, life happens, and if you have other pressing financial priorities, contributing to your retirement may seem like something to worry about in the future.

But no matter how deep in debt you are, you should be saving (at least a little) for retirement. Otherwise, you’ll miss out on valuable compound interest. Using your income tax return to contribute to your RRSP is an excellent way to ensure you are saving for your future without reducing your disposable income.

The opportunity cost is too high to ignore. Let’s look at an example.

Let’s assume you are 25 and you receive the average income tax refund of $1,641 every year. You have debt that you want to pay off, so you decide to use your income tax refund to save for retirement while you focus on debt repayment.

You contribute $1,641 per year to your RRSP for five years and invest that money in a low-cost index fund yielding a 5% return. At age 65 you will have $38,969.57. That’s without adding any additional money after the first five years! If you start to make regular contributions after your debt is paid off, you’ll end up with even more.

Another bonus of contributing to your RRSP is that it lowers your taxable income for the next year, increasing the size of your tax refund next year.

For many Canadians, their income tax refund represents an opportunity to splurge or treat themselves. But for the truly financially savvy, an income tax refund is a chance to achieve their financial goals. Join the financially savvy tribe and use your income tax refund to improve your financial situation. Your wallet will thank you!


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