Question. Hi, I filed my taxes a little while ago, and just recently received my tax refund. It’s significantly more than expected, and I’m wondering if you have any suggestions on what I should do? I want to enjoy some of it, because I feel like it’s “free money” that wasn’t previously accounted for in my budget. But I also see it as an opportunity to make some progress, and do something constructive as well. Do you have any suggestions?

Answer. When it comes to income tax refunds, one thing is for certain – it’s a lot more pleasant getting a refund than being told we owe the CRA more money. So how can we put our new found wealth to good use?

Well, it may be very enticing to take the refund and go on a nice vacation to the Caribbean. However, there are also some excellent ways a tax refund can be used within your financial plan, and it’s important to review your financial situation, and your short- and long-term goals, to determine the best use of that money for you.

Keep in mind is that everyone’s situation is different, and what makes sense for one may not make sense for another. With that in mind, let’s take a look at some of the ways you can put your tax refund to good use.

1. Pay down debt.

Remember, there’s an important distinction between “good debt” and “bad debt.” In general, high-interest consumer debt, such as credit card debt, is about as bad as it gets. Many credit cards have astronomical interest rates, sometimes upwards of 20 percent or more. Other debts, such as car loans and lines of credit, may not carry interest rates as high as some of the major credit cards, but those rates may still be quite high. So using your tax refund to address these types of debts is always a good idea. Keep in mind, however, that other forms of debt may be advantageous to maintain. For instance, investment loans and student loans may carry much lower interest rates, and the interest on those loans may be tax-advantaged and present additional tax-planning opportunities. In short, you would be generally well advised to attack high-interest, non tax-advantaged debt first.

2. Make this year’s RRSP or TFSA contribution.

You can make your RRSP contribution for 2018 at any time throughout the 2018 year, or within the first 60 days of 2019. Why wait? If you have the means to invest sooner rather than later, you’re generally better off doing just that. Also, it may be more beneficial to contribute to a spousal RRSP rather than your own RRSP. Contributing to a spousal RRSP is essentially an income-splitting strategy, which, depending on your own unique circumstances, may be more effective than contributing to your own RRSP. A spousal RRSP is generally advantageous if your spouse is expecting a lower income in retirement, thereby achieving an income-splitting benefit.

As for TFSA contributions, the maximum amount you can deposit into your TFSA this year is $5,500. However, your total contribution is cumulative, so any amounts unused in previous years are carried forward indefinitely. As long as you have a valid SIN and are at least 18 years of age, the $5,500 maximum TFSA contribution is available to everyone, regardless of income. Although there is no real TFSA contribution deadline per se, again, why wait? Waiting until December to make your annual contribution simply means missing out on a full year of tax-free growth.

3. Make a charitable donation.

Donations made to qualifying charities are eligible for a tax credit. The value of the charitable donation tax credit varies from one province to the next, as described on the Government of Canada website. Note that there is no limit to the amount that you can donate in any single year, but there is a limit to the amount that is eligible for the tax credit – that limit is currently 75 percent of your net income, which is extended to 100 percent in the year of death and year prior. Keep in mind that donations must be claimed after they are paid, and, as such, pledges are not eligible for the tax credit.

Another potential strategy here involves the donation of publicly traded securities (such as stocks, ETFs and mutual funds) rather than cash. Essentially, if you have investments that have increased in value, donating those securities completely eliminates the taxes you would otherwise owe on the capital gains. In addition to eliminating the capital gain, you’ll be entitled to a charitable donation receipt for the full value of your securities donated. You could then use to tax refund to re-purchase the securities in your investment portfolio.

4. Make a lump-sum mortgage payment.

Using your tax refund to reduce the balance on your mortgage can provide you with substantial savings in the long run. But be careful, early payment can sometimes involve penalties, so be sure to check the terms and conditions of your mortgage. Lending institutions, such as banks and credit unions, often charge a fee for mortgage payments made ahead of schedule. However, there is often some flexibility for additional payments. What may not be immediately obvious is how much can actually be saved in the long run, because paying down principal today can make a huge difference in interest paid throughout the lifetime of the mortgage. So much so, that in some cases, it may still make sense to incur the penalty for an early payment, depending on the amount of interest saved in subsequent years. Of course a decision like this would be highly specific to each individual. But in most cases, making lump sum payments on your mortgage can save you significant interest costs in the long run.

5. Build your emergency fund.

Having an easily accessible pool of money for use in case of emergency is a great idea, and should provide you with good peace of mind. Most experts advise that your emergency fund should be enough to cover approximately 3 – 6 months of living expenses – rent or mortgage payments, heat and utilities, groceries, auto and insurance payments, child expenses, etc.

So what are some of the emergencies that people face? Job loss, medical and dental emergencies, car accident or car repairs, death in the family, unexpected home damage and related repairs, and unplanned travel related expenses are perhaps the most common. Unexpected events such as these can be both costly and stressful, and can potentially derail an otherwise sound financial plan. An emergency fund is a reserve set aside specifically to deal with situations such as these. Note that new granite countertops aren’t on the list – your emergency fund should be used only for an emergency!

Bottom Line: Your Tax Refund

So what’s the best choice for you? The answers are as unique as you are – there is no one size fits all solution. In many cases, the best choice will be to split the refund and use it in two or three ways. If you have any other questions about your tax refund, or about any of our other products and services at ModernAdvisor, just ask us.