If you contribute to your RRSP on a regular basis and have a tax refund owing to you every year, what do you do with the money? Certainly you will hear the opinions of your friends, family and colleagues telling you to put it HERE or use it THERE – and you may be wondering what the right answer might be?
Personally I’m of the belief that as long as you do something productive with it, you’re on the right track. Nonetheless, let’s look at the most popular options:
1. Contribute more to your RRSP
This is productive because you are adding even more money to your retirement savings. Of course, if you maximize your RRSP’s then this is not an option. (And GOOD FOR YOU by the way!)
2. Make a lump sum payment to your Mortgage
This is a very popular option, especially for those who don’t really know if accelerating the mortgage or maximizing your RRSPs is the best use of your discretionary funds. Since any extra payments to your mortgage go directly to reducing the principal owing, you will knock off a tonne of interest payments in the future for every extra dollar you pay off now.
3. Pay off Other Debts
Especially if your interest costs on your credit cards is in the double digit range. Suppose you have an interest rate of 19% and you carry a balance on your credit card. By paying that off, it’s like getting a 19% return on your money. If you find that your RRSP refund doesn’t completely pay off your high interest debt, perhaps you might consider reducing your RRSP savings and increasing your debt repayments. The logic is that the investments in your RRSP are probably earning less than what you are paying in interest.
4. Contribute to an RESP for your Children
This piggy backing of refunds is very effective, and feels great too. Not only are you getting money back from contributing to your RRSP, you are effectively growing that refund by using it to generate at least 20% more in the form of the Canada Education Savings Grant. Oh yeah: you’re also helping to fund the education of your child!
5. Pay for an Insurance Portfolio
While this doesn’t increase your net worth as much as some of the aforementioned items, it does make your overall financial picture more robust. Insurance can be expensive and quite frankly, for some people, the costs turn them off so much that they don’t carry insurance period. There is something about the nature of an RRSP refund that makes it feel like "found money" and in some cases people who don’t like paying for insurance out of their monthly cash flow may find paying for it on an annual basis with the RRSP refund more palatable. Remember, personal finance is as much about psychology as it is math!
6. Discretionary Spending
By this I mean something like an annual vacation. Again, it’s not as good for your balance sheet but getting back to the psychological nature of finance: some people view the RRSP refund as a reward for the hard work of saving on a regular basis to their RRSP. If this annual vacation serves as a positive reinforcer to you to keep on saving in the future, then that is much better than saving to your RRSP one year, using the refund to pay down the mortgage and then not saving the next year because you "lost the faith".
7. Create a Rainy Day Fund
If you don’t have an emergency fund, some might consider putting the money into a high interest savings account until you have 3 to 6 months living expenses accounted for. In today’s day and age, and with the abundance of credit out there, many people are avoiding the rainy day funds since they feel they could tap into their RRSP’s, home equity, or lines of credit for emergencies. It’s a personal choice and there is no clear "winner".
8. Contribute to a Non-Registered Investment Portfolio
This portfolio might be to supplement retirement, or perhaps it is for a future "non-retirement" linked purchase. For example a cottage, home renovations in the future, or just a general "fun money" fund for whatever strikes your fancy. Going back to point 7, it could also serve as an emergency fund if an emergency were to strike.
9. A Combination of any or all of the above mentioned items
If you are on the fence as to which is the best option, remember that there really is no clear winner. If it makes you feel better, you could spread the refund around to multiple different strategies, or you could alternate based on one strategy this year and a different strategy next year.