Use your tax refund to build your wealth

With the end of another RRSP season, tax season is just around the corner; T4s, T3s and RRSP receipts are filing in. Many readers have asked, "What's the best thing to do with tax refunds?"

Principles of cash flow

The answer lies in something I call the principles of cash flow. Unfortunately for most of us, our incoming cash flow is limited, usually in the form of a regular paycheque.

What we must do is ensure our outflow (otherwise known as expenses) like taxes, mortgage payments, utilities, car payments, gas, food, entertainment, etc., does not exceed our inflow. I know this sounds basic, but budgeting is one of the basic elements of financial planning.

In his book, The Millionaire Next Door, Thomas Stanley says a common trait of the wealthy is that they know where they spend their money. Understanding cash flow will help you determine the best place for your money.

Three types of expenditures

Ultimately, whatever you do with your money can be broken down into three basic categories of expenditures.

No-value expenditures

For some expenses, once your cash is used the money is gone. I think everyone understands what I mean. Things like food, utilities, clothes, entertainment, etc.

These expenditures do not contribute to building wealth. This category includes necessary expenditures (like food) but sometimes also far too many unnecessary expenditures (like entertainment). Filling your cash flow with too many unnecessary things is often fun — but not productive.

Depreciable expenditures

In this category, the item you purchase may have value, but that value depreciates over time. The most common depreciable expenditure is a car. Most of us consider a car an asset because it has value, but every year, the car we own has less and less value.

Cars depreciate, and often faster than we would like them to. Obviously, a depreciable asset is better for wealth building than a no-value expenditure because it at least contributes to our net worth.

Appreciable expenditures

Using your money in this category is the most productive for wealth building. Assets like GICs, real estate and even mutual funds, go up in value over time. Using your cash flow for these types of investments will be the most fruitful use of your money.

Often, they are not as fun or exciting as spending money on that new big-screen TV or fancy car, but it is the best for improving your financial picture.

Look at your bottom line

A key benchmark in your financial planning is your net worth. Your net worth is simply what you own minus what you owe. A primary goal of your financial planning should be to increase your net worth year over year.

To do that, you must know what your net worth is. If you do not know what your net worth is, take some time to write down everything you own (i.e., that have financial value) on one side of a piece of paper. Then, on the other side, write down all the things that you owe (e.g., mortgages, credit cards, lines of credit, etc.) and subtract. To make it easier, use MoneySense.ca's a handy net worth calculator. You can find it in the RRSP/RRIF Tools section.

Once you know your net worth, the rest is simple. You must either increase the things you own or decrease the things you owe. Obviously, in building the things you own, you will be far better off owning appreciable assets because they work for you. Depreciable assets work against you, and no-value items should not show up on your net worth statement.

Back to the question

So what should you do with your tax refund? The answer should be the same answer to, "What should I do with my cash flow?"

The best thing to do with your tax refund is to use it productively — towards building your net worth. Take a look at what I call the principles of cash flow:

You've heard me say it before and you will hear me say it again; it is all "Simple, not easy."

All this stuff is really simple and full of common sense. If that's the case, then why don't more people do it? It's not easy to do. Financial planning is all about trade-offs and discipline. The people who succeed are the ones who just do it!

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Jim Yih is author of Mutual Fundamentals and Seven Strategies to Guarantee Your Investments. He is the founder of CORE Financial Advisors and Account Representative of Manulife Securities International Ltd. Commissions. Jim can be reached through his Web sites Wealthweb.ca, Retirehappy.ca, COREFinancial.ca and JimYih.com.