What should I do with my tax refund?

Do you remember the good old days when spending our tax refund frivolously wasn't such a big deal? Our jobs were stable, house values seemed to be on a never-ending climb and the stock market was booming. Things were looking pretty good.  Well, we are all feeling a little less wealthy these days; our portfolios have been beaten up, the wealth in our homes have taken a blow and on top of all that, we are worried about our jobs and the stability of our income.  There is a lot of insecurity or fear out there and so spending our tax refund on a great vacation or a new flat screen TV may not be the most financially savvy thing to do.

So what should we do with this year's tax refund- spend it or save it, invest it or splurge?

Well, that all depends. In these tough times, it is a good idea to give some thought to your overall financial health with the first and most obvious area being your emergency reserves.  Lets take Karen for example, a 42 year old marketing executive with a small independent firm who wants to know what she should be doing with her estimated $10,000 tax refund. In past years, Karen just reinvested her refund into her RRSP but this year things have changed. Karen's company has been hit hard by the economic slump and has been hinting that layoffs are eminent. Although Karen is a long time employee with seniority she is not immune to layoffs.

The first thing Karen needs to do is evaluate her existing emergency savings funds to ensure that she has at least 3 to 6 months of living expenses set aside. Knowing that you have some backup money just in case can definitely ease some of your anxiety about what may happen. If Karen has little in the way of savings, a tax refund can give her the means to start building up a reserve. I would also suggest that Karen open up a low rate line of credit to help make up for the shortfall in savings. It is easier to qualify for debt when you have income, keeping in mind that this line of credit is ONLY to be used to help pay bills or pay emergency expenses.  

Let's assume that Karen does have an adequate emergency savings fund, how then should she best use her tax refund?

Karen should review her overall debt load and either consolidate her loans into one low rate loan or start aggressively paying down any high rate loans.  You would be quite surprised at how many people have no idea how much they owe and what it is actually costing them to borrow it. Most often this is because we have way too much debt and it's all over the place.  So we need to simplify our debt. We can do this by taking all our loan statements to our banker and ask if they can consolidate them into one, low rate, manageable loan. If you have only one loan payment, it not only makes life much simpler but also makes getting out of debt much more 'doable'. Now if you have some high interest rate loans that you cannot negotiate into a lower rate loan then I would highly advise you to make it a priority to start aggressively paying them down. Use your tax refund here.

What if you have already paid off your debt and have a sizable emergency fund- then what? 

Lets say that Karen has a healthy savings accounts and no debt with the exception of her 4% mortgage, what then should she do with her refund?  Today's low interest rates and stock markets make it a good time to invest versus paying down debt. Karen is in a high tax bracket, has a long time horizon and is a moderately aggressive investor who should yield between 7-8% over the long term. With all this in mind, investing versus paying down her 4% mortgage makes more sense for her. And since Karen's tax refund was earned by making contributions to her RRSP, then why not continue the cycle and invest back into the RRSP creating an ever-growing nest egg. The $10,000 contribution would generate a $4,000 refund at the 40% marginal tax bracket, which she can throw back into the RRSP again next year.

 So what should you do with your tax refund?

It's important that you understand your unique financial circumstances before making any decisions. Use the refund productively and resist the temptation to spend it on frivolous items. In the long run you will be better off having money in the bank, with little to no debt then a big TV or 'just' the memory of a two week vacation........