5 ways to spend your tax refund

The average income tax refund last year was $1,500, according to the Canada Revenue Agency, and it's likely many of those lucky recipients are hard pressed to remember where it went.

If you're one of the three in four Canadians to get one this year here are five ways to make your tax refund — or any windfall for that matter - the seed that blossoms:

Pay down debt

Imagine an investment that is guaranteed to return thirty per cent, compounding annually, with no risk and no tax consequences. That's basically what you're getting if you pay down the balance owing on retail credit cards like those offered by The Bay, which can charge as much as 29.9 percent. Any investor would drool at that sort of return yet thousands of consumers carry balances at those rates.

Even basic credit cards like Visa and MasterCard charge rates on balances in the upper teens.

Putting your tax refund against debt, even consumer loans nearing ten per cent, can prevent a lifetime of financial stagnation. You won't have much to show for it right away but you'll thank yourself down the road.

Paying down low interest car loans, secured lines of credit or mortgages may be less fruitful but there are more effective ways to invest your tax refund.

Open up a TFSA

At the start of 2012 over eight million Tax Free Savings Accounts had been opened up since the Federal government introduced them four years ago.

The TFSA provides a unique opportunity for savers to grow their money tax free. All gains made from a long list of eligible investment stay in your pocket and not the government's.

For many Canadians on a tight budget finding extra cash to start a TFSA is elusive but it only takes a few hundred dollars to get the ball rolling. Afterward a hundred here and a hundred there can turn into significant savings.

Even if you're one of the eight million plus TFSA holders it wouldn't hurt to top it up. The total contribution limit will increase by $5,000 (plus inflation) each year in addition to the current $20,000 maximum built up over the past four years.

Make an early RRSP contribution

While you're topping up your savings consider putting your tax return in a Registered Retirement Savings Plan. An RRSP contribution allows the investor to deduct the full contribution amount from his or her taxable income.

It's the contribution that keeps on giving. By contributing your tax return to an RRSP you avoid the last-minute rush before next year's March deadline and get an early start building next year's tax refund.

It's important to know that while contributions are tax deductable, the contributions and any gains from investments in an RRSP are fully taxed when they are withdrawn - but that usually occurs in retirement when the plan holder is in a lower tax bracket.

Buy more of what you like

If you're a prudent investor you probably hold a few good stocks in your TFSA or RRSP that pay dividends, or you feel are poised to rise when the broader markets turn up.

Good stocks are good stocks and the more you own, the better. Using your tax return to buy more can bulk up your holdings.

Even better, good stocks that are down from your original purchase price provide an opportunity to buy more at a better price — lowering your average cost per share and your break-even point.

Roll the dice

Why do investment advisors go on and on about diversification? Because a diversified portfolio opens up a wide range of growth opportunities while spreading out overall risk.

Diversification most commonly applies to sectors and geographic regions, but it should also apply to risk itself.

A well diversified portfolio includes low-return potential/low-risk investments at one end of the risk spectrum and high-return potential/high risk investments at the other end. As a result, losses at the high-risk end will be cushioned by the low risk investments, and gains will pull up the low risk investments.

If you have a good low-risk anchor you owe it to yourself to take on more risk at the opposite end — and that's where you can have some fun with your tax refund.

Do your homework and shop for a high risk stock with strong growth potential. A great starting point is the TSX Venture Exchange, which is packed full of what are considered penny stocks - small companies that trade on low volume.

Good examples are start-up resource firms sitting on huge reserves that are poised to either strike it rich or get bought up at a premium from bigger resource companies.

Then again, they could go bust — and that's where the fun lies.