How to Optimize your RRSP Contributions

Posted 18 Jan 2017 by Rick Irwin, CFP, CLU


Winter brings many things for Canadians; for winter sports enthusiasts it’s as welcome a season as any, while for others it's dealing with clearing of snow and ice and waiting for warmer days and a return to golf, gardening and other pursuits. In the investment industry winter is associated with another ’season‘; income tax and the associated deadlines with filing tax returns before the April 30 deadline and the first 60 day cutoff for making RRSP contributions to reduce taxes payable for the prior year.

It's been well ingrained into us that RRSP contributions are a good thing, both in terms of the long-term accumulation of wealth and the shorter term tax savings. For most Canadians, RRSPs can be the smartest retirement savings vehicle. However, in many cases we can be too caught up with short-term tax savings to appreciate some of the bigger picture short and long-term tax opportunities and/or consequences.

For the typical investor, I would expect RRSPs to yield a greater retirement nest egg than other savings strategy, such as TFSAs. RRSPs offer greater urgency to save given the deadline oriented nature and potentially large up front tax savings. The money is also more likely to be left invested than TFSAs as there are large tax penalties for early withdrawals, which isn't the case with TFSAs.

These behavioural considerations aside, from a purely mathematical standpoint we've always preached that RRSPs will yield the better outcome so long as one’s tax rate when they are contributing is greater than the tax rate when they take the money out. (If the opposite is true, TFSAs will yield the better outcome.)

When is a TFSA a better choice than an RRSP? http://trinitywealthpartners.ca/resource-centre/tfsa-vs-rrsp-part-2-when-is-one-plan-better

 

But simple tax rates don't tell the full story. Taking it one step further will help you better assess the total economic benefit of making an RRSP contribution versus a TFSA, as well as the total tax consequence of the withdrawal from either plan in retirement.

To gauge the total economic benefit of making an RRSP contribution during your working years we recommend you assess the following:

  1. The rate of the tax refund you will be receiving. Ideally it's generally best to only make RRSP contributions when the refund level is at the second tax bracket or higher and not the lowest. If your RRSP contribution is being written off against income in a higher rate you are buying yourself greater certainty that you will be better off in the long run as you are more likely to withdraw the money at a lower rate.
  2. Additional benefits that may accrue to you by lowering your income. One example of this for working families would be receiving an enhanced Canada Child Benefit. 

Example: John and Mary both live and work in Nova Scotia and earn approximately $70,000/year each. They have two children between the ages of six and 18. Their marginal tax rate is 37.17% so they will receive this amount back on any RRSP contributions they make within this marginal tax zone. But they will also increase their (tax free) Child Tax Benefit by 5.7% by lowering their income so the effective benefit of making the RRSP contribution is 42.87%.   

Looking at the other side of the coin, withdrawals, one should be mindful of more than just the tax rate at which the funds will be withdrawn. After age 65 there are additional tax credits such as the pension income amount and the age amount, which together represent a combined $1851 credit against taxes payable in Nova Scotia. Just gauging a 37% refund at the time a contribution is made versus a 30% tax rate when withdrawing money doesn't tell the true story. These additional non-refundable tax credits should also be factored in.

Working years: income $70,000

 

RSP contribution

 $  10,000.00

Marginal tax bracket

37.17%

Tax refund

 $    3,717.00

Additonal Canada Child Benefit payment (5.7%)

 $        570.00

Total benefit to making RSP contribution

 $    4,287.00

Total RSP benefit: %

42.9%

   
   

Retirement years: income $40,000

 

RRIF withdrawal

 $  10,000.00

Marginal tax bracket

29.95%

Taxes payable

 $    2,995.00

Pension income amount

-$       403.11

25% of age credit (assumes RSP income is 25% of total income)

-$       361.94

=Effective tax rate: $

 $    2,229.96

=Effective tax rate: %

22%

 

This is not to suggest that one vehicle is inherently better than the other. TFSAs are superior for shorter to medium savings goals while RRSPs generally should be used for retirement. TFSAs can and should also make up part of the overall retirement income pie and can actually be a better long-term savings vehicle. It's important to take a big picture view in looking at which savings strategy is best: TFSAs, RRSPs or both. With our 360̊ plan approach, we aim to strike the right balance between maximizing tax savings and related benefits now while maximizing after tax income in retirement.

For our in depth analysis of TFSAs versus RRSPs, check out our series: http://trinitywealthpartners.ca/resource-centre/tfsa-vs-rrsp-part-1-which-plan-is-best


 

The information provided is based on current laws, regulations and other rules applicable to Canadian residents. It is accurate to the best of our knowledge as of the date of publication. Rules and their interpretation may change, affecting the accuracy of the information. The information provided is general in nature, and should not be relied upon as a substitute for advice in any specific situation. For specific situations, advice should be obtained from the appropriate legal, accounting, tax or other professional advisors.