Why do Canadians willingly prepay more income taxes than required, at the expense of investing and benefiting from the time value of money? If you believe in the power of compounding, you’ll raise an eyebrow at the size of the average income tax refund in Canada this year: slightly more than $1,600, or about $130 a month. That number has risen dramatically over the past several years. In 2006, just six years ago, the average tax refund was $1,240, or 27% less.
With the debt-to-disposable income ratio at a record high of debt is 152% of household income and Canadians saving only 4% of their disposable income, they could certainly use that money in more financially productive ways — for example, to pay down debt and save for retirement. Reducing the amount of income taxes withheld from paycheques would create savings room and this can make a big difference in wealth accumulation and preservation.
Think of what you could do with the extra money. You could maximize contributions to Tax-Free Savings Accounts (TFSAs) and RRSPs, for example. According to Statistics Canada, only 26% of 24.5 million eligible taxpayers — about six million Canadians — contributed to an RRSP in 2010 (Knowledge Bureau Report, Feb. 1) and contributed slightly less than $3,000 (the median contribution was $2,790). In fact, some 21 million taxfilers had unused contribution room.
As for TFSA, by June 2011 the average account held only $6,354 out of $15,000 in available room, according to Investor Economics. (Today, available room has gone up another $5,000 to an accumulative $20,000). A survey commissioned by Bank of Montreal in November 2011 found only 44% of Canadians had TFSAs and those investors left tax-free compounding room on the table, investing on average only $3,700 a year. If they put the average tax refund to work, they could have contributed the $5,000 maximum.
In today’s volatile markets, when investors are eeking out small returns, it’s important to maximize every available new dollar of income and shelter it from taxes. Reducing your income tax prepayments will put more money into your hands with every pay period and allow you to leverage your investment returns tax-efficiently.
Indeed, tax-efficient investing begins when you take control of the first dollar you earn. So, take a good look at the amount of taxes you are paying at source. Start the process by taking stock of the various deductions and credits to which you’ll be entitled in 2012 — a tax pro can help — and then ask your employer to reduce your withholding taxes. Two forms will help: the TD1 Tax Credit Return and the T1213 Request for Reduction of Tax at Source.
That way you’ll get back your refund with every pay period — instead of waiting until the spring of next year.
It’s Your Money. Your Life. Make the time value of money work for you. Remember, indebted governments expect you to be more self-reliant in the future; you’ll be better able to do that if you reduce withholding taxes and invest the difference.