Investing Your Tax Refund: Failing to Reinvest your Refund undermines an RRSP’s efficiency
The Financialist • Issue 132 • January 2017
BY BRYN HAMILTON, BA CFP FMA
The idea of a tax deduction against your taxable income and the refund it generates is a very attractive idea to many. That vacation we had been thinking about all year is finally afford- able knowing we have that nice chunk of money coming our way. But wait… there’s one little problem. By spending this money we are compromising the effectiveness of our retirement plan.
This is not “free money”, we are simply getting the tax dollars back that we have already paid during the year. Furthermore, depositing money into RRSPs is still a pre-tax environment, so we ultimately owe the applicable taxes down the road. RRSPs were created in 1957 with the idea that the refunds that we would generate would find us in a higher tax bracket than the taxes we have to pay when we withdraw the money. So we need to understand that when we have assets in an RRSP account there is a future tax liability that we need to account for.
We can’t be mistaken about the value that is represented on our statements. What we need to be aware of is After- Tax dollars. Money still in our RRSP account is all Pre-Tax dollars, meaning every dollar that is withdrawn from our RRSP account is taxable. So if we know that our RRSP account has a future tax liability, by reinvesting our initial tax refund, in a way we are pre-funding this future liability. Not only that…we can put it to work as well by having it invested for all the years until we need to pay for that liability.
One way to look at it is as follows. We keep our tax refund (X) generated from the initial RRSP contribution at a higher tax bracket. Then we invest it (X + Growth) and pay taxes (Y) on the way out at the lower tax bracket. So now we have (X + Growth) – Y.
To make this an efficient strategy, we want X to be greater than Y. Let’s take a look at some basic numbers assuming a 30% tax bracket upon contribution and withdrawal. If we were to invest $10,000 per year into a RRSP account for 20 years at 6% growth and NOT reinvest the refund, we would have $367,856.
If we were to withdraw the money at a 30% tax bracket, our tax liability would be $110,356, leaving us $257,500 to spend in retirement.
Now, let’s look at the more efficient method which is reinvesting the tax refund we received from our initial contribution. This would roughly equate to $13,000 in annual contributions to the RRSP ($3,000 is our refund and $10,000 is our contribution). The $3,000 reinvestment into the same RRSP account generates a further tax refund of about $900 with the option of reinvesting this back into the RRSP to create a further tax refund and so (we will call this the Bonus Refund).
Over 20 years, our RRSP would grow to $478,213 excluding the Bonus Refund. What this means is that we now have at least enough money to cover our original tax liability of $110,356 ($478,213 -$367,856 = $110,356) and more to spare through the Bonus Refund. By reinvesting the tax refunds we have $478,213 + Bonus Refunds Pre-Tax ($334,749 after tax, not including Bonus Refunds) compared to $367,000 Pre-Tax ($257,500 after tax). So by reinvesting our $60,000 of tax refunds ($3,000 per year for 20 years), we have increased our retirement lifestyle by $77,249.
A lower tax bracket upon withdrawal (which is generally a pre-requisite criteria) simply makes the outcome even better, but using the same tax bracket for the contribution as well as the withdrawal outlines the importance of investing the refund.
What this has done is prepared us better for the future tax liability to come so we are not left with a scenario where we need to tighten up our budget at a time where ideally we would be comfortable and enjoying life.
Another thing to note is that you can also use your tax refund for other purposes and still have it contribute to your finan- cial well-being. You could be contributing it to your TFSA, Non-Registered account, child’s or grandchild’s RESP; paying down your mortgage, car loan etc…
So remember, it’s not “Free Money’”