Tax refunds: Why less is more

Are you looking forward to an income tax refund? If you’re like most people, you probably are — and who can blame you — it’s free money, right? Well, not exactly. In this article, we explain the nature of a tax refund and an alternative to potentially help you reach your investment goals faster.

Tax refund or lower source deductions?

A tax refund is simply a return of overpayment in prepaid taxes taken from your pay cheque throughout the year.

As you earn employment income during the year, your employer is obligated to withhold a portion of each pay cheque as payroll withholding amounts. Amounts withheld include income tax, Canada pension plan (CPP) contributions, and Employment Insurance (EI) premiums, all of which are remitted to the Canada Revenue Agency (CRA) on your behalf. The withholding amounts are calculated based on predetermined formulas.

When you file your income tax return for the year, you reconcile the amount of income you earned and claim any allowable deductions (to reduce your income that is subject to tax) and tax credits (to reduce tax payable) to determine your ultimate tax liability.

If your tax payable is lower than what was already withheld and remitted to the CRA on your behalf, you will receive a tax refund. As you can see, the prepaid amount is essentially a tax-free loan (from you) to the government, which puts it to use until you receive a tax refund.

On the other hand, a lower source deduction allows you to keep the money that belongs to you as it’s not remitted to the CRA in payroll withholding — instead it goes directly to your bank account. This is done by informing the CRA of certain deductions and tax credits you expect to claim. The CRA will review the request and authorize a reduction in payroll withholding by informing your employer to withhold a lower amount per pay cheque.

Why does reducing source deductions make sense? 

There are two main reasons why reducing source deductions may work better than a tax refund. First, it provides you with extra monthly income that can be invested right away, as opposed to waiting for the big cheque a few months into the following year, assuming you file your income tax return before the deadline. Second, having extra cash flow each month makes it easier to stick to your regular savings/investment strategy, especially when combined with an automatic investment service, namely a pre-authorized chequing (PAC) plan.

Here’s an example of the positive effect of reducing tax at source:

Amy lives in Ontario and earns an annual gross salary of $80,000, or monthly gross income of $6,667. She makes personal RRSP contributions (not deducted at source from salary) of $400 per month and incurs $500 per month of childcare expenses. As a result of applying to the CRA to reduce source withholding tax, Amy’s required payroll deductions are reduced thereby increasing her take-home net pay by an extra $279 per month.

Amy invests that extra cash each month at an annual rate of return of 4.5%. For a fair comparison, we will assume the same lump-sum amount would be otherwise received as a tax refund and invested once a year after filing her tax return ($3,348, calculated as $279/month × 12 months). We will keep the same rate of return (4.5% per annum) and investment period. In practice, the amount of the actual tax refund is impacted by other income, tax credits, or deductions and may not equal the monthly extra cash flow multiplied by 12. 

Over the course of 30 years, Amy’s monthly contributions of $279 are expected to grow to $212,663. She earns $11,760 more in comparison to investing the same lump-sum tax refund once a year. If the amount is invested within a tax-free or tax-deferred environment (e.g., registered retirement savings plan (RRSP) or tax-free savings plan (TFSA)), no tax is paid throughout the investment period (if invested within a TFSA, the entire amount can be withdrawn tax free).

The difference between investing monthly and annually may not seem attractive enough at first; however, remember that the extra net pay does not require any extra income earned, it just means less withholding tax taken throughout the year. Here are some arguments in favour of smaller but more frequent investments:

1. When the investment is automated through a PAC, the extra cashflow is automatically transferred to a financial institution for investment each month with no additional effort required. By completing the necessary tax and investment-related forms, you simply reduce the tax at source and increase your take-home pay, which allows you to redirect the increase in monthly pay to your investment portfolio. When you choose to invest the extra income per pay cheque, you are in the same position from a take-home pay perspective when compared to not implementing this strategy at all — yet you are tucking away extra money for investment each month.
2. Automating the monthly investment keeps things consistent across all market environments and reduces the anxiety involved when markets become turbulent. This is due to the smaller purchase amounts involved. When receiving a large refund once a year instead, you may second guess the timing of the investment as less opportune and not proceed to invest the refund at all! In the long run, this could lead to a large opportunity cost.
3. A dollar now is worth more than a dollar next year. With all things being equal, the opportunity to get a tax refund immediately and place that money into investments earlier will have a positive effect on investment performance in the long run.
4. While the annual tax refund can also accumulate a decent amount of savings over the years, it hinges on having the discipline to consistently execute the strategy on an annual basis. As the process is not automated, it requires discipline and effort on the part of the individual. A potential detractor relates to how well one can resist the temptation to consume the tax refund (e.g., on vacations).

Effectively, automating the plan reduces the human element that may hinder the ability of the individual to stick to the plan over the long term. From a behavioural finance perspective, having a regular, relatively smaller automated purchase plan increases the chances of strategy endurance over the long term. As we know, it’s time in the market over the long term that can have the biggest positive impact to one’s investment success.

How to get started?

Follow these three simple steps:

Step 1 – Complete the CRA form(s)

Two CRA forms are relevant – TD1, Personal Tax Credits Return and T1213, Request to Reduce Tax Deductions at Source. (Commissioned employees may use Form TD1X, Statement of Commission Income and Expenses for Payroll Tax Deductions in addition to Form TD1.) Both TD1 and T1213 forms take into account tax deductions and credits that you intend to otherwise claim at tax time, and that information will be used to reduce your source withholding per pay cheque.

Form TD1 is typically completed when you have a new employer, however it can be resubmitted if your circumstances have changed. The TD1 form contains certain tax credits that can be declared, such as the tuition tax credit, pension income tax credit, disability tax credit, eligible dependent tax credit, etc.

Form T1213 can be filed with your local tax office to request reduced source deductions where the deductions and tax credits you wish to claim are not listed on Form TD1. Form T1213 contains an expanded set of deductions and tax credits, including registered retirement savings plan (RRSP) contributions, childcare expenses, support payments, employment expenses, medical expenses, and donations, to name a few. Supporting documents are required to substantiate the amounts claimed in the form. Also, in order to file T1213, your previous years’ income tax returns need to be assessed and any amount owing must be paid in full. The request is generally filed every year with the CRA. However, if you expect the same amount being claimed from year to year, you may submit the request every two years by providing a separate form for each year.

Step 2 – Submit the CRA form(s)

Form TD1 is submitted/resubmitted to your employer.

Form T1213 must be sent to your local tax office as indicated on the last page of form. After reviewing and approving your request, the CRA will issue a letter of authority, which you can provide to your employer to start deducting less tax from your pay cheques.

Step 3 – Start a pre-authorized chequing (PAC) plan

Whatever amount you gain each pay period by reducing your tax at source can be automatically transferred to your investment portfolio through a PAC plan. Since your contribution is deducted directly from your account at your financial institution, the transition is seamless. You can set up a PAC plan at Invesco with the help of your financial advisor.