The Problem with Tax Refunds
You may have seen an article published on April 29 by CBC about “angry and frustrated” teachers who find themselves in the unfortunate position of having their tax refunds delayed. This is because the Eligible Educator School Supply Tax Credit that many teachers had claimed had been increased for the 2021 tax year but the bill enacting the increase had not yet been passed. As a result, the CRA is unable to complete the processing of the returns which have claimed this credit. Approximately 50,000 teachers are affected by this situation.
I am not now going to begin a rant on the current state of federal legislative processes. Rather, what is striking to me as a financial planner is that one teacher expected a tax refund of $12,467 while another is expecting $4,061. Both teachers needed to borrow money, one by putting some needed expenses on her credit card, and the other by borrowing from her mother.
I sympathize with these teachers as well as others who are waiting for – and indeed relying on – their tax refunds to take care of essential spending. They seem like collateral damage in the complex legislative process, and it is too late to tell them they should have forgone the tax credit for now so they could have gotten their refund in a timelier manner. Regardless, there are lessons to be learned for the years ahead.
The General Attitude Toward Tax Refunds
I dare say that almost universally across Canada, taxpayers look forward to their tax refunds. As much as people do not like to file their tax returns, when that big fat direct deposit drops into your bank account, you feel good. And the bigger, the better.
Tax refunds are perceived by most, I believe, as an essential part of one’s cash flow. The classic dilemma with the tax refund is whether it should be used to contribute to one’s RRSP or to pay down the mortgage. For one teacher, though, it was viewed as the cash that was needed to deal with an increase in utility bills. For another teacher, it was an important part of her student loan repayment.
That a tax refund would be necessary to address routine monthly expenses such as utilities and student loans suggests a financial management problem.
I am also surprised by the size of the refunds. As public employees, teachers are typically part of solid defined-benefit pension plans that use up a substantial portion of the room that would otherwise be available for RRSP contributions. Often, large refunds are given to taxpayers because they do not belong to employer pension plans, but they have the income and the room to make large contributions to their RRSPs. Two of the teachers quoted in the article were from Alberta. According to the Alberta Learning Information Service (ALIS), an elementary school teacher earns on average $77,661 per year. If we use that figure but assume the taxpayer in question does not have a pension plan, this person is in a combined Federal and Alberta tax bracket of 30.5%. In other words, every $100 contributed to an RRSP would result in a tax deduction of $30.50. Let’s suppose the taxpayer maximized RRSP contributions each year which was set at 18% of earned income up to a maximum of $27,830 in 2021. At that rate, the maximum contribution would be $13,978.98. If that amount were deducted from income at the marginal tax rate of 30.5%, and assuming no other taxes were payable, a tax refund of $4,263.59 would be due.
For this blog post, the issue is not so much maximizing the RRSP contribution as it is the effect that a contribution has on taxes due. When your employer deducts your contributions to your pension plan or your group RRSP, those are taken off before tax is remitted to the CRA. When you contribute to your personal RRSP, that is done with after-tax income, resulting in a tax refund – or a reduction in tax owing – when you file your return. Depending on your circumstances, there may be other actions you can take to further reduce your taxes. The point is that these and other actions often generate a tax refund, which as noted before, is something people look forward to.
What You Should Probably Want
The problem with this situation of tax filing followed by a tax refund is that you have essentially given the government an interest-free loan. If you could more closely match the amount of tax that you owe with the amount of tax that is withheld by your employer, that could make a significant difference in your monthly cash flow. In the case of the teacher who is expecting a tax refund of $12,467, that works out to nearly $1,039 per month in extra cash. Even for the teacher anticipating the $4,061 refund, she could find herself with extra cash of about $338 per month on hand.
This may sound counterintuitive, but I would argue that ideally, you should wind up with tax owing when you file your return. Just as the government does not attach interest to your refund, neither do they charge interest, as long as you pay any amounts owing by the due date. This doesn’t happen too often for those who only earn employment income, but if you run a small business, own a rental property, or receive taxable investment income, you may find yourself owing tax when you file. That way, you get an interest-free loan from the CRA, not the other way around.
As one might expect, there can be too much of a good thing. If you owe more than $3,000 in taxes twice within 3 years, the CRA will insist that you start making quarterly payments.
How to Bridge the Gap
One way to reduce the amounts remitted to the CRA by your employer is to take a careful look at a couple of tax documents to see if there are any opportunities for you to make some changes.
TD1 Personal Tax Credits Return
The first form, the TD1, is likely something you routinely receive from your employer. Most of us will use the first item, the Basic Personal Amount, but several other credits might be applicable, including for pension income, tuition, or disability, among others. This form is given to your employer.
T1213 Request to Reduce Tax Deductions at Source
The T1213 is another form that you may find useful if you routinely receive large tax refunds. You send this completed form to your Taxpayer Services Regional Correspondence Centre. Once approved, you will get back a letter which you will, in turn, give to your employer, authorizing the reduction in the tax being withheld at source. Items you can claim include RRSP contributions, child care expenses, medical expenses, and donations, among others.
The Value of the Emergency Fund
Finally, let me put in a plug for establishing an emergency fund. Whether or not a tax refund is something you build into your expectations for cash inflows, as these teachers’ situations illustrate, it is useful to build up a reserve of cash that can tide you over when expected money just doesn’t arrive on time. Rules of thumb typically suggest you set aside a minimum of three months of living expenses. Those who have gone through financial hardships brought on by COVID-19 may prefer to save an even greater amount. If you have nothing in reserve, you cannot suddenly turn off the tap and save three months of expenses in three months, but it is something that you can work toward.
This is the 146th blog post for Russ Writes, first published on 2022-05-02.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.