So you’ve made a contribution to your RRSP this year. Great! You should be proud of being proactive with your savings (you’re already doing better than a lot of people). Now, what are you going to do with the tax refund?
When you contribute to your RRSP, you’ll typically generate a tax refund. This is because your employer withholds a certain amount of taxes on every paycheque based on your annual income. At tax time, your RRSP contribution is subtracted from your income, and you only owe tax on the remaining amount. The difference is returned to you as a tax refund.
Depending on your tax bracket, that could mean you get as much as 54% of your contribution amount back!
This refund can seem like free money, and it’s tempting to use it for something fun after saving so diligently all year long.
But what if you took the refund and immediately invested it back into your RRSP? Your future self will thank you!
Here’s why.
Reinvesting your tax refund into your RRSP each year allows you to take advantage of the power of compounding. This is the process whereby your investment earnings generate additional returns, which then also earn returns themselves, leading to exponential growth over time.
This accelerates the growth of your retirement savings, helping you reach your financial goals sooner.
And by consistently reinvesting your tax refunds, you create a snowball effect. You generate another refund every time you do so, which can in turn be reinvested.
Take someone with a 40% marginal tax rate who is able to contribute $10,000 to their RRSP this year. This would generate a $4,000 tax refund.
Assuming they planned to contribute another $10,000 in the subsequent tax year, they could boost that to $14,000 by immediately reinvesting their refund.
The $14,000 contribution would then lead to a $5,600 refund, allowing for a $15,600 contribution in the following year. And so on.
Over time, this strategy can help you use up more of your allowable contribution room and catch up on missed contributions from previous years.
What if you don’t quite have enough to contribute to retirement and all of your other goals too?
Your tax refund can help free up cash flow throughout the year. If you’re finding it challenging to save for retirement on top of all your other needs and lifestyle goals, your tax refund can help you. Simply reinvest the refund for whatever else is important to you – travel, renovations, kids’ education, etc. Sure, it won’t create that compounding, snowball effect to accelerate your retirement nest egg, but it will allow you to accomplish more of what you want.
Your financial planner is a great resource to explore your options and choose the best strategy for your situation.
Do you have the discipline to reinvest your tax refund?
When you spend your tax refund instead of reinvesting it, there’s a significant opportunity cost in terms of lost future returns on your investments. Remember compounding? The earlier you invest, the more the magic of compounding helps grow your savings.
Having a plan in place can help. If you’ve mapped out your finances for the year, you’ll know what’s available to spend in each area of your budget, so you’ll be less tempted to splurge on something extra.
A detailed financial plan also allows you to see the future impact of reinvesting your refund. Talk about motivation!
RRSPs are one of the most powerful wealth building tools available to Canadians because they allow your savings to grow tax-free. Over the long term, reinvesting your tax refund every year can significantly boost your RRSP balance. Adopting this strategy as part of your overall retirement planning approach could help you reach your goals sooner.
So, what are you going to do with that tax refund this year?
Book a call to learn how much of a difference reinvesting your tax refund could make for your savings goals.