Reader’s Question #3

Q: As someone in their mid-20s earning $32,000 in Ontario, who expects to earn more in the near future (~$40,000), is it worthwhile for me to invest in RRSPs, or is it better to save up the unused contributions for a couple of years until the tax break is bigger? I have heard that if you are making less than you expect to make when you’re retired, then the tax benefit is lost. Of course the money would be invested, just not in a registered plan. Comments?

A: A quick look at the marginal tax rates for Ontario will show your first tax bracket changes over when you hit $35,488 in income for 2007. So for now there isn’t much of a point going for an RRSP since you most likely will be in the same tax bracket in retirement. Yet once you do pass that mark you start to climb brackets again at $37,488 and then again at $62,485. So once you are earning over $40,000 I would try to contribute enough to drop you back under that $35, 488 bracket for the most tax savings. That $4512 RRSP investment could generate about another $1295 in a tax refund. If that’s too much to save try to get back under that $37,488 bracket by investing $2512 and you would get about a $879 tax refund.

One very useful thing you should take advantage of with your current low income bracket is the negative taxation on dividends that qualify for the enhanced tax credit. Basically the government gives you a tax credit for your dividends you get, but once your in the lowest tax brackets you actually get a larger credit than your tax bill would normally be, so you actually reduce your regular income tax by an additional 5.97% of what you got in dividends (For example $100 in dividends would reduce your regular tax bill by $5.97). I know it is a very weird idea to wrap your head around at first but this is great thing for investors with low income like yourself since you can actually keep every penny plus some extra on every dollar of dividend income.

As per usual, I’m not a tax expert or financial adviser, so do your own homework. Any additional ideas/comments from anyone else would be appreciated.

8 thoughts on “Reader’s Question #3”

  1. Great post Mr. Dream!

    Good advice about the dividends. Your reader might also want to consider plowing down the mortgage (if he/she has one).


  2. One thing that you’ve forgotten in your answer is that RRSPs involve two things:

    1) Making a contribution
    2) Claiming a deduction for contributions.

    People often assume that you need to do both in the same year, but it’s not true. You can contribute money to your RRSP now (and get extra years of growth) and save the deduction for a future year when you’re in a higher tax bracket. You are NOT required to claim the deduction in the same year that you make the contribution.

  3. FT,

    That’s true, if you can reduce the mortgage now it saves lots of interest.


    Good point. I forgot to mention that one.


  4. Re the dividend credit, if I held a mutual fund through a broker in my name, would my wife be able to claim it on her tax return?

  5. Alex,

    No. The investment will be taxed in by whom ever made the investment. So if you want your wife to get taxed on something, she has to buy it.

    Also be careful with mutal funds many of the gains they have are a blend of interest, captial gains and dividends. So your tax bill is often hard to predict.


  6. Alex,

    If the low income earner earned the dividends, they can transfer the dividends to the high income spouse. This is only effective if the new tax created by the higher income is lower than the increased spousal credit.

  7. I’m the one who asked the question–thanks for the great answer!

    I have heard similar thoughts from others who I’ve discussed this with. However, your answer puts it very simply–if I am in the lowest tax bracket now, I won’t be any lower when I retire!

    To answer some of the questions posted in the comments, I do not have a mortgage at this point. I am saving for a down payment on a house (when I move for the new job…) but at this point those savings are in a high interest savings account (I want something liquid at this point, and am unsure where else to stash it). One option was to put the money in an RRSP and then take it out via the “Home Buyer’s Plan”.

    Also, I’ll have to investigate the “negative taxation on dividends” that you mentioned.

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