Canadian individual tax form T1 close-up
© minichka / 123RF Stock Photo

With the tax season upon us, many Canadians are anticipating a tax refund from the CRA. In fact, for tax returns processed between Feb. 11 and March 4, 2019, the average refund amount has been $1,747, according to the CRA. The agency’s goal is to send refunds within two weeks when you file your tax return online and eight weeks for paper returns.

While receiving a refund certainly has psychological benefits, the financial impact tends to be viewed less optimistically. But is such pessimism warranted?

A tax refund is a sign that you paid too much income tax throughout the year. Effectively, you provided CRA with an interest-free loan while missing out on a little extra money each paycheque; hence the pessimistic financial view.

However, a cost/benefit analysis shows there may be circumstances where such pessimism is overstated.

The first step is to determine the cost of the “loan.” For that, we will use the most recent one-year Treasury bill rate of 1.86% on a refund of $1,747, assuming your client is paid monthly. Based on these assumptions, the client is missing out on $14.97 of annual interest—not a huge loss.

The next step is to decide what the client would have done with the money. Receiving the refund as additional income with each monthly paycheque would have meant an extra $146 per month. If this was destined to be spending money, it becomes a timing decision: Would the client have preferred to receive it monthly or as a lump sum at the end of the year?

If the client had saved or invested the money, however, the time horizon and expected return could have generated meaningful benefits. Table 1 shows the benefits of saving $146 per month for one year in a savings account versus for 10 years at 6% in various registered accounts.

Table 1: Benefits of saving $146 per month

1-year savings account @ 2% 10-year RRSP @ 6% 10-year TFSA @ 6% 10-year RESP @ 6% 10-year RDSP @ 6%
Future value $1,763 $4,248 $3,034 $3,641 $9,113
Tax* ($6) ($1,699) $0 $0 ($1,473)
Net amount $1,757 $2,549 $3,034 $3,641 $7,639

* A marginal tax rate (MTR) of 40% was applied to the savings account and RRSP. An MTR of 0% applies to the RESP assuming the funds are withdrawn as an EAP and the student has no income. An MTR of 20% was applied to the RDSP’s earnings and the grant upon withdrawal.

The longer the time horizon and better the expected return, the more money at the end. The one-year savings account option provides only $10 more than the lump sum refund net of tax of $1,747. This does not provide a strong financial incentive over receiving a lump sum refund, especially if the client intends to simply spend the money.

The RRSP balance is impacted by the future marginal tax rate, which is assumed to be the same as today’s. However, it is not uncommon for retirees to be in a lower tax bracket during retirement than their working years. Such circumstances would lead to a higher after-tax benefit. Finally, the RESP and RDSP provide the added benefit of matching government grants.

Alternatively, your client could use the $146 each month for debt repayment. Table 2 shows the benefits of using free cash flow to reduce these debt balances and save interest.

Table 2: Benefits of using $146 per month for debt repayment

Credit card @ 20% Line of credit @ 6% Loan @ 8% Mortgage @ 3%
Principal payment $1,747 $1,747 $1,747 $1,747
Interest savings $169 $49 $66 $28
Total $1,916 $1,796 $1,813 $1,775

Naturally, the higher the interest rate, the bigger the interest savings when making an additional $146 monthly payment, versus waiting a year and making a lump sum payment of $1,747. Debt repayments also reduce the balance outstanding, shortening the time it takes to pay the debt in full.

Changing your refund amount

If clients would like to reduce or eliminate the size of a potential refund, there are two different forms to complete:

  1. TD1: by completing the federal and provincial versions of this form and returning them to the client’s employer, income taxes at source can be adjusted based on the amount of personal credits the client will claim on his or her tax return.
  2. T1213: after completing this federal form, the client must send it to the appropriate taxpayer services regional correspondence centre on an annual basis for approval, which can take four to eight weeks. The client then submits the approved documentation to his or her employer for further adjustments to income taxes at source. This form allows you to apply tax deductions and credits in addition to those found on the TD1 against income.

The financial benefits of reducing income taxes on a client’s paycheque versus receiving a refund will be impacted by how they intend to use the funds. If they plan to spend the money or use it for short-term savings, there is very little benefit to receiving the extra money with each paycheque.

However, if your client has a long-term investment or a debt repayment goal, the benefits of receiving the money throughout the year can outweigh the lump sum refund. Consider how your client will use the extra money and when they would like to receive it. And remember: money coming into a bank account is always better than money leaving it.

Editor’s note: This article was originally published in the April 2018 issue of Advisor’s Edge. It was updated in March 2019 with numbers for the current tax year.