Tater’s Takes: Tax Refunds Are Not Windfalls

September 11th, 2014 by Potato

I haven’t had a Tater’s Takes round-up post in approximately forever. Preamble: early summer was crazy at work, so it was good that I finished the draft of my book in the spring so it could sit with the editors over that time. Several people now have copies in their hot little hands and are providing great feedback so I can make one last round of polishing before I start getting proofs made up. I’m getting super excited for the book. I’ve put a tonne of effort into it (way, way more than I expected when I thought I’d just make a PSGtDIYI 2nd edition) and I think it’s shining through in the manuscripts. Most people who haven’t gone completely silent have praised the initial copies, particularly novices to finance (the target audience). There’s still almost two months to go before I run out the clock on the window to hear back from publishers, and at this point I almost want to get rejected because it’s just so close to being ready to go in the self-published route that it would hurt to have to pause to work out the details with a traditional publisher.

Blueberry is (as every proud daddy will say, I’m sure) uncanny smart sometimes. Like most toddlers, she has become attached to a blanket as her “lovie”. We’ve heard the horror stories of kids who lost their lovies or those that get disgusting because it’s hard to separate them long enough from the child to wash, and Wayfare planned in advance. We bought multiple copies of the blanket in question, and have kept them in rotation so there’s always a clean one ready and so that they all have the same degree of wear. These blankets are identical in every way, right down to their electrons sharing the same spin states. So we were caught completely off guard when Wayfare surreptitiously did the blankie swap for laundry and Blueberry instantly noticed and freaked out. How could she tell? How could she tell so quickly and decisively? Baby genius, that’s the only answer.

Ok, links.

First up is yours truly, scraping the bottom of the barrel for active investing ideas. I hardly post at all on that topic, and considering I’ve got a book on how easy index investing can be coming up it was best to shunt it to another venue. Nelson was kind enough to host this post on HNZ over at Financial Uproar.

I’ve just discovered Steve at Kapitalust. I’d suggest starting with this recent post on the intersection of ethics and investing.

Sandi’s back! Or semi-back, as someone else takes over half-way through.

Robb at B&E preaches about the inevitability of changes to embedded commissions for advisors in Canada.

Michael James has a new twist on comparing car salescritters to mutual fund salescritters and why embedded commissions make more sense for one than the other.

Oh, so this is public now.

Dan at OBFW reviews a new book (not mine, despite what you may think when you see the title — I’ll unveil the title of mine in just a few more weeks, be patient kids) and raises an interesting question: “Would you rather get a $1,000 windfall at age 27 when you are trying to scrape together a down payment for a house or a $1,300 windfall at age 70 when you have close to $1 million in savings?” in suggesting that young people use their RRSPs over TFSAs (and spend the refund).

I think that’s unfortunate framing. A tax refund on an RRSP contribution is not a “windfall” — it’s a deferral of a government obligation. Michael James puts it best when it calls it the government’s share of your RRSP. Of course the short answer is that if you really need the money to buy a car or pay down debt then you should just use the money for that rather than investing it and then redirecting a part back towards the more urgent need in a roundabout way that involves filing paperwork with a large government agency. But let’s do the math on this suggestion:

Let’s say you scrape together $1k to invest while you’re in the 20% tax bracket at 27, and expect to end up withdrawing in retirement at age 70 in the 31% tax bracket. We’ll use 6% real returns. If you suddenly realize, no, you need $200 of that back to pay down some debt you forgot about or to buy something shiny, then you could either put just $800 in your TFSA, or contribute $1k to your RRSP and spend the $200 refund.

If you just trusted your original decision to invest $1000 in your TFSA, you’d have $12.3k to spend in retirement. But to be more fair, the invest-$800-in-your-TFSA scenario would leave you with $9800 to spend at age 70. If you put the $1000 in your RRSP and got a $200 refund to spend on stuff then you’d only have $8453 to spend after the CRA took their cut in retirement. Spending the government’s share and mistaking the TFSA vs RRSP issue adds up to a much bigger deal than just $1000 when you’re young or $1300 when you need it less — you could spend the same “windfall” amount on whatever necessities you have when you’re young in that case, still use your TFSA, and come out way ahead.

If you only decided to spend the refund because it came months later and you were weak (and you didn’t get commiserate value from the dollars spent), then picking the RRSP over $1k in the TFSA would be like borrowing $200 from your future self and paying an interest rate of nearly 7%. But, maybe spending $200 now is more important than spending $3847 when you’re 70 and don’t need it. Of course that logic of “X now is more important than Y later” can lead to a lot of debt if you don’t put some reasonable limit on it.

Nelson also posted about why he prefers the RRSP to the TFSA. I left a weak, off-the-cuff comment about why I still like the TFSA. One other point that came to me when re-reading it is the issue of the refund timing: if you run the math, assuming you’ll be in the same tax bracket before and after retirement then the two shelters come out neck-and-neck in terms of outcomes. If you end up in a lower tax bracket the RRSP provides an advantage; higher and the TFSA will win out. However, the canonical comparison assumes you invest with pre-tax money and avoid withholding (or have the funds available to invest the refund in advance). In practice not only do people run the risk of squandering the refund, it also tends to come later, so the TFSA gets a tiny, miniscule head start on compounding (when looking at it from multiple decades in the future). Anyway, nitpicky.

4 Responses to “Tater’s Takes: Tax Refunds Are Not Windfalls”

  1. Michael James Says:

    Thanks for the mention. I tend not to get too excited about the RRSP vs. TFSA debate because I max out both. Advising my son, though, I did suggest starting with a TFSA and worrying about RRSPs when his income rises.

  2. Steve Says:

    Thanks for the shout out! Really enjoying going through your archives and soaking up wisdom/knowledge!

  3. Potato Says:

    At some point I keep meaning to make the archives more manageable. I created a list of all posts in reverse chronological order to make that a bit easier, as the monthly archives can be cumbersome, and the categories aren’t much better.

  4. save. spend. splurge. Says:

    You know, I think it’s the smell / taste of it. If it’s too clean / doesn’t taste the way they left it, they can tell.