Tax Time: Are You Getting a Big Refund?

It's that time of year again... tax time in Canada. This year every Canadian must file their 2017 taxes and pay any amounts owing by April 30, 2018. That's a little more than two weeks from today.

As most of you know, taxes in Canada are quite complicated. I always do my own tax returns using Genutax. There are other great software programs out there as well: Simpletax, Turbotax, and Studiotax for example. Doing your own taxes is a great way to understand how much tax you are paying and what you can do to reduce that amount as much as possible in the future. Trust me, the nice lady at the mall kiosk doesn't care.

Our tax system is a myriad of credits and deductions at both the federal and provincial levels. Child care, RRSP contributions, medical expenses, education, charitable contributions, union dues, interest costs, pension adjustments, kids fitness, arts, and whatever your government decides is good for you at that moment in time.

After you plunk all those numbers in your tax return, you find out if you get a refund from the government or if you owe them more money than what you already paid. What is the best outcome?

Getting a Nice Refund

Most people are very happy when they get a refund cheque sometime in April or May. However nice this little bonus might seem, it is NOT the ideal outcome. Do not confuse a refund with some form of extra income. Extra income is something like the Canada Child Benefit or Old Age Security--money from the government that is not really paid by you but which you receive on a regular basis because you meet certain criteria. A refund is getting your money back because you paid too much to begin with.

Put it this way... you go to the store and buy a pair of pants that cost $100 but was marked 20% off. The clerk made an error that you didn't immediately notice and charged you $100 plus tax. You paid full amount, stuffed the pants into your backpack, hopped on your bike and were halfway home when the thought crossed your mind that you paid too much. You check your receipt and sure enough the discount wasn't calculated, so you bike back to the store and get your $20 back.

Did you earn back that $20 from the store? Absolutely not! You made the purchase expecting the discount amount so you are simply getting a refund because the store collected to much money from you in the first place. It's actually inconvenient because you wasted your time, effort, and dignity by going back to the store and grubbing for that $20 you never should have paid in the first place. This simple mistake makes you obliged to the store rather than the store being grateful for your business.

Tax refunds work the same way. Your employer follows some standardized criteria to deduct money for taxes from each paycheque all year long. It's not tailored to your personal situation and is actually designed to make sure you pay more than you need to.

By giving the illusion of having the government owe you rather than you owing the government, you are now at their beck and call. You will file your tax return on time, you will appreciate anything they give you back, and if they dispute something you've done on your return, they hold back money which is rightfully yours until you prove yourself innocent.

The government wants to give you a refund because it's insurance. Also, it ensures they get paid first and it gives them an interest free loan that grows all year. If five million Canadians get an average refund of $500 every April, that's an accumulated free loan of $2.5B every year.

If you get a tax refund every year, especially a big one, you are doing something wrong. You should first ask your employer for a TD1 form. This form allows you to direct your employee to adjust your tax deductions lower for things like the age amount, caregiver amounts, education amounts, and disability amounts.

Next you need to look at the T1213 Form. The T1213 must be sent to the CRA after you complete because they must provide approval before your employer can reduce tax deductions. The T1213 allows you to deduct things like RRSP contributions, child care expenses, family support payments, investment loan interest expenses, and many other items.

By completing a TD1 and T1213 accurately, you should be able to drastically reduce the amount of your tax deductions each paycheque and the size of the tax refund every April. The only downside is this must be done every year, however the pay-off is worth the postage stamp.

Pay a Little More Tax

This might sound a little counter-intuitive, but if you are doing your tax preparation correctly every year you should actually be paying the CRA a small amount after your tax returns are done each April. I'm not talking thousands of dollars that you can only pay with a line of credit because you don't have the cash on hand, but a moderate amount that you can afford is perfectly fine.

While your co-workers brag about the size of their refund, calmly cut the government a cheque and understand you are better off for it. Not unlike using a credit card to collect points or cash back, it's alright to be in debt to the government as long as you pay them back when you are supposed to.

Enjoy filing your taxes in the next few weeks and if you are getting a refund, check out the TD1 and T1213 to make sure it doesn't happen again! Of course, if your refund is due to RRSP contributions make sure you put that money into your investment account because you will owe taxes on RRSP withdrawals down the road. If your refund is not because of RRSP contributions, still invest it and put that money to work for your future self!

Comments & Questions

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Please visit my new website and blog for current posts on financial topics. DArends.com

TFSA or RRSP or Non-registered Investment Account

In Canada investors and savers have three primary accounts in which they can place money for retirement. All these accounts will allow you to invest in a wide range of financial securities. The most common securities include bonds, publicly traded stocks, mutual funds, ETFs, and publicly traded REITs both domestic and foreign listed.

The biggest difference between these accounts is how they impact your personal tax situation. Taxes, unfortunately, can become very complex even at the individual level. This unnecessary complexity is why all these special tax treatment accounts, like the RRSP and TFSA, have been created.

Read this post to get an understanding of investing and investment taxation across different accounts.

The complexity of these special accounts have given a distinct advantage to people who hire professionals to assist them with their finances (generally the wealthy crowd), or Canadians who have taken the time to understand the implications of each account on their wider tax and benefit situation.

Lets discuss the differences between these accounts and which accounts you should choose for your situation.

TFSA

Tax Free Savings Accounts are available to every Canadian over 18 years old. The annual contribution is capped at $5,500 (in 2018), but the contribution room amount is cumulative if you don't put money in your TFSA. You contribute to a TFSA with after-tax money, but you don't pay any taxes on withdrawals. Any investment returns made within the account, including dividends and realized capital gains, are not taxed.

Under the current system, you don't even need to report withdrawals from your TFSA account on your income tax forms. This means, if all your income is from a TFSA, you could appear to have ZERO income and maximize your benefits in retirement--including benefits designed for very low income seniors such as the Guaranteed Income Supplement (GIS).

RRSP/RRIF

Registered Retirement Savings Plan is a tax-deferral account available to every Canadian who files taxes. The annual contribution limit is equal to 18% of your earned income up to a maximum contribution increase of $26,230 (in 2018); unused RRSP room is cumulative and can be carried forward. You get a tax refund for RRSP contributions at your highest marginal tax rate, but you must pay full income taxes on withdrawals from RRSP accounts. Realized income kept within the RRSP account are not subject to tax until withdrawals are made.

Once RRSPs are converted to a RRIF (Registered Retirement Income Fund), any withdrawals you make are eligible for the Pension Income tax benefits and can be split with your spouse. RRSPs must be converted to a RRIF when you turn 71. RRIFs have mandatory withdrawals which are based on your age and the value of the account. The minimum withdrawal rate increases as you get older. You may not make any contributions to a RRIF account.

You can make withdrawals from a RRSP account when you are working, but the withdrawals will be added to your other income and be taxed at full tax rates. However, you can "borrow" money tax-free from your RRSP using the Lifelong Learning Plan (LLP) or Home Buyers Plan (HBP). You are required to "pay back" your RRSP when using these special plans. If you don't make those payments, the minimum required repayment for that year is added to your income and taxed as if it were a RRSP withdrawal.

Non-registered Investment Accounts

These are standard investment accounts which receive no special tax sheltering or deferral treatment. There are no limits on how much money you can contribute to a non-registered investment account, which makes them the default choice once contributions to registered accounts have been maxed.

Taxes on certain types of investment income--Canadian dividends and capital gains--are lower than taxes on employment income. You must pay taxes on any gains you realized during each tax year which reduces your net investment returns. Due to the lower realized investment returns after taxes, registered accounts (RRSP/TFSA) are often preferable to non-registered accounts. You can make your non-registered accounts more tax efficient by investing in products that do not generate income and where capital gains can be deferred for long periods of time. Swap-based index ETFs are a good example of this.

Low Income Comparison ($40,000)

Source: TheRichMoose.com

When you are in a lower income situation, you will find minimal differences between the accounts. From a pure income tax view, the RRSP with reinvestment of the tax refund is the best choice, just slightly beating out the TFSA. That's because you would slightly benefit from the difference between the highest tax rate on contributions and a lower blended tax rate on withdrawals. This small difference is mostly due to the basic personal deduction. Non-registered accounts do quite well for low income individuals because the tax rates on realized gains within the account along the way do not significantly impact returns and can actually reduce your overall tax bill in certain situations.

Middle Income Comparison ($70,000)

Source: TheRichMoose.com

If you are in a middle income situation, you will find the RRSP account with reinvestment of the tax refund to begin pulling away from the other options. The spread between tax refunds on the RRSP contribution and taxes owing on the RRSP withdrawals to increase. Even with relatively careful investing, the actual return on investments after taxes in the non-registered account will begin to suffer more.

High Income Comparison ($120,000)

Source: TheRichMoose.com

If you are a higher income individual, RRSP accounts should be your first priority. The spread in tax refunds on RRSP contributions and taxes owing on RRSP withdrawals continues to grow. Also, you must be very careful how you manage any investments in your non-registered investment accounts because the taxes on realized income there get quite punitive! Again, the TFSA is always a reasonable option that performs well.

It's Not This Simple

If you take a quick look at these charts, you might assume it is always best to invest in your RRSP first--as long as you reinvest your tax refund. While the RRSP is certainly a decent choice regardless of your income, the way our system of tax credits and other social benefits are designed makes it much more complex.

The real answer of the best account for you depends not just on your gross income, but also on your spending and total savings rates. For example, a reasonable person earning $120,000 should be saving much more than $5,500. You should save at least 10% of your gross income if you start young, expect a reasonable retirement, and will have a paid-off house by the time you retire in addition to your investments.

An individual saving $12,000 per year returning 6% over a forty-year period will see their account grow to nearly $2 million. You can't invest $12,000 per year in a TFSA, so you will be forced to save in your RRSP from that perspective. However, if your RRSP is worth $2 million at retirement, your tax rate on $80,000 of RRSP withdrawals will be quite high (22.09%). You will also get benefit clawbacks at this level of income.

RRSP accounts are also less flexible than TFSA or non-registered accounts. When you turn 71, your RRSP must be converted to a RRIF and you must make mandatory withdrawals from the account at a rate that climbs higher every year--even if you don't need the money. Since RRSP withdrawals are taxed similar to employment income, they are more difficult to access during your working years as well.

When RRSPs Should Be Prioritized

Although there are numerous complexities involved and it's never very straightforward, you should consider making the RRSP your first priority if you:

  • Are more educated in financial planning and are serious about reducing income taxes
  • Will always invest the tax refund back into your RRSP
  • Have a moderate to very-high income when you are working (over $50,000)
  • Don't spend a lot of money relative to your income
  • Plan to retire early so you can reduce your RRSP before it must become a RRIF
  • Have a very small amount of money to contribute and want to maximize your total investment value
  • Make sure your RRSP account doesn't get too big so you can keep your withdrawals to a minimum
  • Invest in a more active style, often realizing gains
  • Will not make any withdrawals for any reason while you are working
  • Might use advanced strategies to reduce taxes on withdrawals (borrow to invest strategies)
  • Will go back to pursue full-time education as an adult
  • Are buying a house in the future after not owning a home for four years
  • Plan to take a sabbatical or otherwise reduce your income substantially before retirement
  • Have an uneven income with very high years and low years (self-employed in resource sector)

When TFSAs Should Be Prioritized

TFSA accounts are newer, but they offer many advantages that RRSPs don't. You should consider making the TFSA the first account to invest in if you:

  • Value maximum flexibility in investments, contributions, and withdrawals
  • Want a tax efficient option that performs well in all income and spending situations
  • Believe you might make withdrawals while you are working for any reason
  • Are likely to spend as much, or more money in retirement than when you are working
  • Think your retirement will include large, but in-frequent expenses (travel, new vehicles, etc.)
  • Anticipate moving from a low tax province while working to a high tax province in retirement
  • Are already contributing to a pension plan that will pay a large benefit in retirement
  • Would like to maximize government benefits as a senior (OAS, GIS, Pharmacare, etc.)
  • Invest in a more active style, often realizing gains

When Non-registered Accounts Should Be Prioritized

In general, non-registered accounts are the account of last resort. This means you have contributed everything you can to RRSP and TFSA accounts. However, there are some exceptions and you should invest in a non-registered account first if you:

  • Have a rapidly rising income and will transfer to a RRSP later to maximize your tax refund
  • Invest in a Canadian dividend strategy, have a low income, and live in a low-tax province
  • Are low income and borrow money from a high income spouse (spousal loan)
  • Borrowed to invest in a tax-efficient way and use the interest expense to offset other income
  • Borrowed to invest so that you can maximize your net worth
  • Want to access a wider range of investments without restrictions
  • Are a very active investor who might be considered a "trading business" by the CRA

Mixing Account Contributions

Particularly for higher income individuals with high savings rates, the best strategy is likely to spread contributions across several accounts. Start with aggressive contributions to your RRSP to get large tax refund. Then you will use the refund money and any other savings to maximize your TFSA account contributions. Finally, whatever is left will go into a non-registered investment account. This is the strategy I employ.

I am targeting a sizeable, but not enormous RRSP account. A target valuation of somewhere around $1 million is probably as high as I want to go. This means I will either stop contributing to my RRSP, or significantly reduce contributions to my RRSP as I reach this value. If I can keep RRSP withdrawals under $40,000 a year per person and top up the rest of my income with TFSA withdrawals or dividends from my non-registered account I will be happy. I will also use interest costs to reduce my taxable income from RRSP withdrawals.

Summary

In Canada the typical saver and investor can save for the future in three different account types: the TFSA, RRSP, and Non-registered investment account. The TFSA and RRSP exist to provide savers with distinct tax advantages. TFSA are "tax-free" after your contribution; RRSPs are actually a tax-deferral mechanism, but you save on taxes by getting tax refunds at a high marginal tax rate but pay taxes on withdrawals at a lower blended tax rate after tax credits and deductions.

While TFSA contributions are not tax-deductible, you can invest in your account without being taxed on investment income and you can withdraw money from your TFSA without paying tax on your withdrawal or even claiming it on your income tax return.

You deduct RRSP contributions from your income, so you get a tax refund which should always be invested. You don't pay taxes on any investment income within your RRSP account until you make a withdrawal. RRSP withdrawals are taxed like regular income and you must report withdrawals on your income tax return. When you are retired, you would normally convert your RRSP to a RRIF so withdrawals can be treated as Pension Income for tax purposes. RRSP accounts are more intricate, not very flexible, but offer several embedded programs for earlier withdrawals. RRSPs are the ultimate account for tax arbitrage if you have a good understanding of the tax system.

Non-registered accounts are normally used after you have already contributed the maximum amounts to your RRSP and TFSA. Investment income from this account is taxed, but at preferential rates for Canadian dividends and capital gains on profitable trades. Non-registered accounts might be used first by individuals who are highly active traders, borrow money to invest, or are waiting until they are higher income before moving their investments to a RRSP. High income individuals should avoid realizing investment income in non-registered accounts.

Generally speaking, the RRSP can be the best account for investing even if you are lower income due to tax arbitrage. However, they are somewhat restrictive and require a reasonably good understanding of income taxes and Canada's social benefit system to get the maximum benefit. The average person is probably best off investing in a TFSA because the flexibility is unparalleled and it performs well in nearly all scenarios.

Side Note: I'm on vacation, so my posts next week will be put up a few days late.

Comments & Questions

This is an archived post and all comments are disabled for management efficiency. You can email me for direct questions.

Please visit my new website and blog for current posts on financial topics. DArends.com