For a lot of Canadians, this is the only time of year that much thought is given to RRSPs. RRSPs have traditionally been the primary means of saving for retirement in a tax-advantaged way. Despite this, operational complexity of RRSPs prevents many from taking maximum advantage of these accounts. As more and more pension plans shift from defined benefit to defined contribution, the effective use of your RRSP will be crucial for fulfilling retirement goals.
RRSPs explained
RRSPs carry two benefits:
- Shifting income between tax years. When you contribute to an RRSP, the amount of your contribution is deducted from your taxable income. If your income is $100,000 and you contribute $10,000 to your RRSP, then in the eyes of the CRA, you only made $90,000 this year. Any dollars contributed to your RRSP directly reduce your taxable income. The general idea is shifting income from your higher earning years to your lower earning years (i.e., your post-retirement years). Since we have a graduated tax system where a higher percentage of income is taken as tax as income grows, reducing taxable income in a higher income year and increasing income in a lower income year will reduce the total amount of tax that you pay.
- Tax-free growth. Any interests, dividends, and capital gains earned in an RRSP are not taxed. The account value can therefore grow without suffering the effects of tax drag.
When funds are withdrawn from an RRSP (or when you have to start withdrawing funds when your RRSP is converted to a RRIF), then any amounts withdrawn directly add to your taxable income. To return to our earlier example, if you earn $100,000 in employment income and withdraw $10,000 from your RRSP, then your taxable income will be $110,000 for the year.
Effective Use of Your RRSP
Now that we’ve nailed the basics of RRSPs, let’s look at how to use them most effectively.
Get your contribution processed on time
RRSPs have an interesting feature: you can contribute in the first 60 days of the new year and still use the contribution to reduce the previous year’s income. For example, RRSP contributions that can be used to reduce 2023 taxable income can be processed up until March 1, 2024. This still presents an issue for some, as personal tax filings frequently aren’t completed until March. By the time your tax filing is prepared and you know how much of an income offset you’d like to have from an RRSP contribution, you may have passed the contribution deadline.
Know your deduction limit
The RRSP contribution limit is 18% of your earned income from the previous year up to a certain maximum dollar amount (this maximum is $30,780 for the 2023 tax year). If your earned income was $50,000 in 2023, your RRSP contribution room you accrued for the year is $9,000 (18% x $50,000). You can find your total RRSP contribution room by logging into your CRA My Account.
Know when to make contributions
Like with TFSAs, contribution room in RRSPs carries forward. If you don’t make an RRSP contribution in 2023, then the contribution limit for the year will be added to your total RRSP contribution room. This allows you to make larger contributions in years in which you earn the highest income.
It can be tempting to make RRSP contributions in order to receive tax refunds, but you should be aware of your current income and income trajectory when deciding to make a contribution. This is best highlighted with a simple example:
- If you earn $50,000 in Manitoba, your marginal tax rate is 27.75%. Making a $5,000 RRSP contribution would reduce your taxable income to $45,000 and save you $1,387.50 (27.75% x $5,000) in tax. If you were earning $100,000 per year, your marginal tax rate would be 37.9% and the same $5,000 contribution would save you $1,895 (37.9% x $5,000) in tax. Your total tax savings would increase by about 37%.
If your income is likely to grow, then your RRSP contributions will be worth more down the road than they are worth today because you will be reducing taxable income in a higher tax bracket. It may therefore make sense to prioritize investing in a TFSA in lower income years.
How work pensions effect RRSP contribution room
Contributions to a registered pension plan (RPP) or deferred profit sharing plan (DPSP) reduce your available RRSP contribution room. If you participate in either sort of plan, then your T4 tax slip will list your pension adjustment, which is the dollar value of your pension contributions for the year. The amount of your pension adjustment reduces your RRSP contribution room dollar for dollar.
Make sure you know your pension adjustment to avoid overcontributing to your RRSP.
Shifting income between spouses
If you are married or in a common-law relationship, you are able to make contributions to your spouse’s RRSP. This is a means of shifting money from a higher income spouse to a lower income spouse. Here are the mechanics of how it works:
- Linda is a high income earner and John is her stay-at-home husband. John has no earned income so he isn’t accruing RRSP contribution room.
- Linda makes a contribution to John’s RRSP (a spousal contribution) of $5,000. This contribution can be used to reduce Linda’s taxable income, and it also counts against Linda’s RRSP contribution room for her personal RRSP.
- This maneuver serves to shift income from the higher earning spouse to the lower earning spouse. Now when John takes money out of his RRSP (or his RRIF when the account is converted), it will increase his personal income instead of Linda’s. Since he is in a lower tax bracket, the couple will pay less tax in total.
Using RRSP loans
We’ve already established that RRSP contributions reduce your taxable income. Borrowing to invest in an RRSP is therefore one of the most tax-efficient ways to borrow to invest. Let’s say you are in the 50% tax bracket, you have $10,000 available to contribute to an RRSP, and your total RRSP contribution room is $20,000. The $10,000 contribution will directly decrease your income for total tax savings of $5,000 ($10,000 x 50% tax bracket). However, if you borrow an additional $10,000 and contribute this amount to your RRSP, your tax savings will be $10,000 ($20,000 x 50% tax bracket). A tax refund of this amount or a deduction in your tax bill of $10,000 will theoretically allow you to pay off the principal of the loan you used to make the RRSP contribution.
First Time Home Buyers’ Plan
This program allows RRSP holders to access funds from their account without increasing their taxable income. Eligible first-time homebuyers can withdraw up to $35,000 from their RRSP toward the purchase of a home as a form of interest-free loan from the RRSP. The homebuyer then has up to 15 years to repay the balance they withdrew from their RRSP. Funds must sit in the RRSP for at least three months prior to withdrawal.
The first time home buyers’ plan effectively allows access to up to $35,000 of tax-free income. The funds are contributed to the RRSP (which reduced taxable income) and the subsequent withdrawal is not subject to income tax. It’s an effective tool for those entering the housing market.
RRSPs are simple in concept, but maximizing their effectiveness takes a bit more deliberation. Take the time to learn how they work and your future self will thank you. Effective use of your RRSP early on can have a tremendous effect on your long term financial standing.
First Home Savings Account (FHSA)
In 2023, the FHSA was introduced as a new tax-efficient way to save money for the purchase of a first house. It combines the best features of RRSPs and TFSAs: funds contributed to the FHSA are tax-deductible like RRSP contributions, but withdrawals are not subject to any tax so long as the funds are being used for a qualified first home purchase. Unlike with the first-time homebuyers’ plan where money is effectively loaned from the RRSP, funds withdrawn from the FHSA are not paid back and are therefore never subject to income tax. While the funds are in the FHSA, they can be invested and they are not subject to any tax on income or capital gains.
The contribution limit is currently $8,000 per year, and unused contribution room carries forward into future years.
Opinions are those of the author and may not reflect those of BMO Private Investment Counsel Inc., and are not intended to provide investment, tax, accounting or legal advice. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness and neither the author nor BMO Private Investment Counsel Inc. shall be liable for any errors, omissions or delays in content, or for any actions taken in reliance. BMO Private Investment Counsel Inc. is a wholly-owned subsidiary of Bank of Montreal.
