In a somewhat unusual fashion I got a comment on this post from a reader, Robert, that basically turned into it’s own post by size alone. Actually I thought Robert did a good job getting in to a few more details than I did in the original post. So give it a read and let me know what you think. -Tim
How valuable is the RRSP deduction?
The Registered Retirement Savings Plan (RRSP) is a government program meant to encourage people to save for their retirement. Up to your contribution limit, you receive a tax deduction for contributions you make. For example, if you are in the 32% tax bracket and contribute $1000, you will receive a refund of $320. In retirement, all withdraws are taxable, so if you withdraw $1000, it will be added to your taxable income.
If you will be in a lower tax bracket (http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html) in retirement than your working life, this can work very well. In the example above, suppose you are in the 25% tax bracket in retirement. You invest $1000 and get a refund of $320. The money doubles by retirement, and you withdraw $2000. At 32%, the tax would be $640, but in the 25% tax bracket you only owe $500, a savings of $140.
There are some potential pitfalls with RRSPs. If you are in the same tax bracket or higher in retirement, you will not reduce your tax bill. The taxes will be postponed, but because all withdraws are taxed, your tax bill could represent the same proportion of your account, 32% in the example above. There are a few considerations to keep in mind. First, the government is constantly changing the tax rates and tax brackets. The tax brackets tend to increase with inflation, but recently the basic personal amount has increased from $8,500 to $10,000 to reduce the amount of tax paid by those who earn the least. On the other hand, tax rates were much higher during the 80s and 90s, and could be increased again. Second, tax rates and tax brackets are different among provinces. If you move from Alberta to Quebec, you are almost assured of paying more tax. Third, certain government benefits (http://www.cra-arc.gc.ca/benefits/) are income-tested. For example, I receive the Child Tax Benefit, but only because my RRSP contribution brought my income down below the maximum.
So, it’s impossible to say that RRSPs always make financial sense. In fact, there are too many variables to really know that you’ll have more after-tax income. But there are certain benefits that make an RRSP useful. One example, as mentioned above, is reducing your net taxable income to qualify for government benefits. Another one is income splitting. When only one spouse works, or one spouse has a much higher income than the other, or when one only spouse has a pension, a spousal RRSP allows the higher income spouse to save and invest in the name of the lower income spouse. That way, it is possible to balance income in retirement and both make use of the lower tax brackets. For example, a couple where one spouse earns $85,000 will pay more tax (in the 36% AB tax bracket) than a couple where each spouse earns $42,500 (in the 32% AB tax bracket).
Even if the RRSP doesn’t reduce tax, only postpones tax, it was always useful for reducing the taxation of interest income. For example, GICs and bonds accumulate interest each year and, even if it is not paid, it is still taxed. Holding the GICs or bonds in an RRSP, or now a TFSA, avoids that tax leakage until a withdrawal is made. A TFSA has a very similar financial benefit, after tax, as an RRSP, but they have different limits and different timelines. An RRSP is meant for saving in anticipation of not working: maternity, disability, sabbatical or retirement. Because withdrawals increase your taxable income, any year that you have little or no income is a good opportunity to withdraw funds from your RRSP.
For someone planning to retire before age 65, without an employer-sponsored pension, RRSPs almost certainly make sense when your income is over about $40,000. Because you can elect to start CPP anytime between age 60 and age 70, and OAS doesn’t begin until age 65, you will likely have less income before age 65. That is a great opportunity to make withdrawals from your RRSP.