The financial obligations to the new year always comes around so fast. First, we finish paying off our Christmas bills and then BAM! RRSP season hits. The deadline to contribute money towards your 2016 RRSP comes March 1, 2017. That means there is just a little over 2 weeks left to come up with the money before the window closes.
Every year the question comes up: “Should I put money into my RRSP?” That’s always a good question. If you talk to the person at the bank or an H&R representative it will always be “Yes, you should put money in your RRSP because you’ll get a refund”. The truth is, it’s not as simple as that.
Whether you contribute to an RRSP or not should really be dependent on your own financial goals. Are you saving for retirement? Do you want to buy a home? Are you planning a vacation? Are you expecting a big raise? Do you have a defined pension? These questions all have an impact on whether you should be using the RRSP account at all.
Short Term Savings
If you are expecting to use your money for a significant expenditure like a car, a wedding or a vacation, then don’t use the RRSP at all. Just because you get a tax refund on your contribution doesn’t mean you are getting more money back. You won’t even benefit from the tax free growth because when you end up taking the money back out you will end up getting taxed at your marginal tax rate. Not only that, you will lose the RRSP room forever once that money is taken out.
If you are planning to use the money in less than a year, save using your TFSA. At the very least, the money or interest you earn will be tax free and after the money is taken out you will get that contribution room back when the next calendar year starts. Keep the RRSP account for long term retirement investing or tax deferral purposes.
Low Income Earners
The RRSP account is solely to benefit the rich. That’s because the RRSP account was designed to shift taxes from early working years to later years where income is lower. People that make a lot of money prosper more because the tax they pay while working is at a much higher tax rate than the one they will pay when they retire.
If you’re a low income earner, meaning you fall within the lower income tax brackets (less than $45,282) then don’t use the RRSP if you have room in your TFSA. Why’s that? Simple. Most people will get a tax refund on their contribution, but then spend it. When it comes time to pull the money out of the RRSP, you get taxed on it. Well, guess what? Low income earners will end up paying the same, if not, a higher tax rate in the future when money is withdrawn. So in essence, by spending that tax refund, you’re actually borrowing from your future self.
Don’t get it? Here’s an example (using federal tax rates only):
- In 2017 you contribute $1,000 while earning $35,000. The $1,000 gets you $150 back ($1,000 x 15% marginal tax rate).
- Ten years later, assuming no change in tax rates and no growth, you withdraw that $1,000. The government taxes you at 15%. So you get back $850.
So you put $1,000 in and take $850 back out. What gives? What happened to the $150? Easy you spent it in 2017. You borrowed from your future self to buy something in 2017. See how the RRSP doesn’t help you at all?
Middle & High Income Earners
So you’re one of the lucky ones that make over $45,282. This puts you into the higher marginal tax brackets. At this point, it may start making more sense to use your RRSP to offset your income if you expect yourself to move into the lower tax brackets when you retire.
If you truly don’t feel that you’ll move above the lowest threshold ($45,282 or probably around $50,000 when you retire) in income levels then using the RRSP can be gainful. The higher your tax bracket is now the more beneficial it will be. Take these two examples:
- In 2017 you contribute $3,000 while making $60,000. This nets a tax return of $615 ($3,000 x 20.5% marginal tax rate)
- In retirement your income drops to only $30,000 putting you into the 15% tax bracket. When the $3,000 is taken out (assuming no changes in tax rates and no gains) the government taxes you at 15% and you get back $2,550.
As a middle income earner, you received $615 in returns and pay $450 on withdrawal when you retire, netting you a gain of $165 by contributing to your RRSP.
High Income Earner
- In 2017 you contribute $10,000 while making $250,000. This nets a tax return of $3,300 ($10,000 x 33% marginal tax rate)
- In retirement your income drops to only $40,000 putting you into the 15% tax bracket. When the $10,000 is taken out (assuming no changes in tax rates and no gains) the government taxes you at 15% and you get back $8,500
As a high income earner in the highest tax bracket, the RRSP is your best friend. The fact you get a return of $3,300 when contributing and only pay back $1,500 on withdrawal means you have netted a gain of $1,800 by contributing. That’s an automatic 18% return. Don’t you just hate rich people!?
Expecting A Raise
If you are expecting a raise at your job that will push you into the higher income brackets then it makes sense to hold off using your RRSP. One benefit of the RRSP is that you can save up the contribution room and use it in later years when you expect your income levels to be in the middle or higher income brackets.
Also remember that tax refunds only apply to the marginal tax rate where your income falls. So if you are close to one of the income thresholds where the tax brackets change, it might be worthwhile to save your RRSP contribution room until you are clearly in a higher income tax bracket.
- In 2017 you earned $46,000. You make a contribution of $1,000 into your RRSP. The net tax return you get is $190.2. ($718 x 20.5% marginal tax rate + $282 x 15% marginal tax rate)
In this example, only each dollar earned over $45,282 is taxed at 20.5%. Since you earned $46,000, only $718 was taxed at that rate. That’s how marginal tax rates work. When you get a refund, only that portion of it will return 20.5%. The remainder will be refunded at the lowest tax rate.
If you are straggling the line, then only contribute or claim the amount where you are paying the higher tax rate and save the rest of the contribution for next year where hopefully you will receive a raise and clear the higher tax threshold by a larger margin. I don’t know where people think getting a raise is a bad idea, always take more money!!!
So you hit the lottery with your job and you have a defined pension. You’re the envy of every worker in the world. Plus, you’re going to have a great income when you retire that might even put you into the middle income earners.
If this happens to be you, then save using the TFSA account. Forgo the RRSP account completely until you’ve maxed out your TFSA and have no other means to contribute to a tax free account. It might even make more sense to save for your kid’s education using an RESP.
When you have a defined pension it’s like you’re already a millionaire when you’re retired, so why worry about saving so much? Go enjoy life on the beach. I hope your workplace gives you additional vacation days.
I absolutely hate these people! Yes, I’m being a hater.
If you’re still confused I don’t blame you. The government and banks all push RRSPs as the be all and end all of retirement accounts, but when you read financial blogs they all tell you differently.
If you’re hesitant to act, my main suggestion to most people is that you should hold off on the RRSP and save using the TFSA first. The TFSA is more flexible, you may not get a tax return back, but you also pay nothing when you withdraw the money. That gives you the most flexibility when it comes to having an investment account available for tax free purposes.
If you ever come back around in the future where the RRSP makes more sense, the contribution room will still be there waiting for you to use.