The Psychology Of A Tax Refund: Why We Love Them, And How To Use Them

Over the years, several people have offered their thoughts about tax refunds and what to do when we get them. The first thing that most commentators point out is that a refund is a de facto admission that you have overpaid through tax withholdings and/or instalments over the previous tax year. Calibrating the amounts you’ll need to remit regularly and then paying accordingly helps.  It is important to incorporate not only your income level, but also the deductions you are likely to incur along the way.

For instance, if you live in Ontario and are earning $100,000, your tax liability would be estimated at $29,986. Nearly 2/3 of that amount is federal, and just over 1/3 is provincial.  It represents a net pay of $70,014. While the last dollar is taxed at a marginal tax rate of 43.2%, the average tax rate is only around 30.0%. Other deductions would include the Employment Insurance (EI) deduction of $953 and the Canada Pension Plan (CPP) deduction of $3,500.

Smart financial decision-making involves taking everything into account. That means meaningful deductions (like business expenses and meals), Registered Retirement Savings Plan (RRSP) contributions, and other circumstantial deductions like charitable gifting and alimony payments can all be applied against your income to lower your tax bill. From a budgeting perspective, it can make sense to have less withheld if you know what these deductions are, and the impact they will have.  Employees should talk to their employer. Self-employed people and independent contractors should adjust accordingly.

Financial planning should be coming into play here. In essence, people shouldn't aim to get a big refund; they should be aiming to get either a small refund or to make a small net payment when they file. Stated differently, people should try to match their remittances with their ultimate tax bill owing. A big refund is an admission of poor planning, and a tax refund is nothing more than the Canada Revenue Agency (CRA) giving you your money back. People who celebrate refunds are misguided. It feels like free money, but it is nothing of the sort.  I could ask my brother-in-law to lend me $100 just so I could give it back to him in the spring for him to “feel richer” and be happier about the newfound money, but… You get the picture.

If, despite your planning efforts, you get a significant refund, you'll need to be sure you approach that newfound money with an attitude that is appropriate for your circumstances. In the interim, you would have given CRA an interest-free loan. With that recalibration of a refund depiction in mind, what are the most sensible options for refund deployment? Here is a list of what you might consider, ranked from the most important to the least important:

1. Pay down high-interest non-deductible debt.
2. Maximize your RRSP.
3. Maximize other government plans like Tax-Free Savings Accounts (TFSAs) and First Home Savings Accounts (FHSAs) (if applicable).
4. Pay down low-interest debt, like mortgages and/or lines of credit.
5. Splurge on a reward for a life well lived.

Let’s go through these in order of priority.

For the love of all that is holy, you should pay off your credit card balances in full every month. If, for some extraordinary reason, you have not done so, then at a minimum, you should arrange for a credit facility to reduce the obligation. Pay off your 18% credit bill by adding to your 6% line of credit (this option should be employed even before you get your refund). It should go without saying, but it is highly unlikely you’ll find (even if you’re lucky) a better use of funds than to pay down (and preferably pay off) high-interest consumer debt. I doubt readers of CMS need to hear this message from a contributing editor, however. More likely, they can show it to a spendthrift child or a wayward co-worker who is in denial about lifestyle choices and prudent forms of remediation.

The second option is to maximize your RRSP. Many Canadians have not done so. Many find it impossible to catch up once they fall behind. Having the government allow you to contribute and deduct 18% of your income annually is a great opportunity that should not be missed if you’re earning a steady income. 

A caveat here is to consider tax brackets when you do this. If you have (say) a $15,000 refund and more than $15,000 of unused contribution room, you may wish to consider topping up only to the point where your taxable income for the following year is on the cusp of a tax bracket. Not every dollar of RRSP contribution offers the same amount of relief. If you can arrange it, it might be better to catch up on unused contribution room over 2 or 3 or even 4 years rather than all at once. You’ll get more money back over time by getting yourself to the edge of a different tax bracket regularly. This is not always easy to calculate, since refunds typically arrive in May and you’ll usually have until March 1 of the next year to make your contribution for the tax year in question. You don’t have to expect accuracy to the last dollar. If you contribute within (say) $3,000 of the bracket change, you’re doing well.

Here's where the third option really makes sense. If you have maximized your RRSP or if you have at least contributed to the point of getting into a lower marginal bracket, the next best use of your funds is often to top up your TFSA. If you’re old enough to have been 18 or older when the program was introduced, your lifetime limit is now $102,000. Again, relatively few Canadians have maximized this program. People who are looking to buy a home someday should consider putting up to $8,000 into their FHSA, as well. The lifetime limit here is $40,000. Beyond that, contributions cannot be deducted from your taxable earnings. Retirement planning often involves a game of “tax arbitrage”, and most people are in a higher bracket when contributing to government plans than when withdrawing from their Registered Retirement Income Funds (RRIFs). Just as you consider contributing only up to the cusp of a lower bracket kicking in, so too, can you withdraw only minimums and supplement them with tax-free withdrawals to support a desired lifestyle without withdrawing amounts that would otherwise put you into a higher bracket. Use the third option strategically.

Paying down low-interest debt is something that often makes sense, but not always. The fourth option is circumstantial and depends largely on personal taste. Reducing your mortgage is good in and of itself, but if the mortgage rate is only (say) 3.8%, you might be able to do better by investing that money, earning more than 3.8% and forgoing paying down the debt. Your call.

Finally, if you’ve managed to make it this far and still have money left to allocate, you can probably spend it on yourself… or your spouse… or your children… or your grandchildren. One of the great pleasures in life is the confidence that comes from knowing you’ve “made it” and that you have enough of a nest egg to be confident that you’re on track and doing fine. We all need to stop and smell the flowers now and again.

Many people love getting refunds because it just feels like found money to them. Again, that feeling usually arises because the people who celebrate refunds often fail to keep track of their ongoing payments and likely deductions. Several behavioural biases might help to explain this. These include:

• The Ostrich Effect, where people bury their heads in the sand to avoid unpleasant things. Not getting a refund needs to be re-imagined as a good thing.
• The Placebo Effect, where people get good vibes simply because they believe the results are good. Major refunds are, in fact, seldom very good.
• The Recency Bias, where people think the recent past is a reliable precursor to the near future. If you got a refund last year, you might deliberately oversave to get the same warm fuzzies this year.

The point in all this is that there are psychological reasons why many of us prefer to get refunds. In fact, getting a refund is seldom something to celebrate, but too often, we succumb to lazy socialization and media depictions to lift our gaze high enough to change our thinking. Do good things with refunds when you get them… then resolve to take proactive steps to make sure you never get another significant refund for as long as you live.

John De Goey is a Portfolio Manager with Designed Securities, regulated by the Canadian Investment Regulatory Organization and a Member of the Canadian Investor Protection Fund. He is also the host of the Make Better Wealth Decisions podcast.