By Ian Calvert on January 10, 2023
The Registered Retirement Savings Plan (RRSP) was created in 1957 and has progressed into a valuable saving vehicle for working Canadians. The concept of creating the RRSP account was to give individuals the same benefits experienced by those involved in defined benefit pension plans.
The two main benefits associated with the RRSP is an immediate tax deduction for each dollar contributed and a tax deferral for all income and gains earned within the account until the funds are withdrawn.
With such meaningful tax benefits, I always find the RRSP contribution rates and amounts in Canada quite peculiar. According to Statistics Canada, in 2020, the proportion of RRSP contributors amount tax filers was 22.3% and the median RRSP contribution was $3,600 when the maximum contribution was $27,230 (understanding this is dependent on the individual’s income).
Although the median contribution amount has been steadily climbing, the proportion of Canadians making contributions to their RRSP has been declining over the last 20 years. For some, RRSP don’t make sense, or perhaps they are involved in a pension plan reducing their ability to make contributions. There is also a group who boldly say, “I’m against RRSPs!”
For these reasons, I thought it would be valuable to take a deeper dive into RRSP and address the question – When are RRSP’s a good strategy? And should every working Canadian be contributing to an RRSP?
My opinion is: it depends. Like many financial planning questions, there is not a one size fits all answer. There are conditions when RRSP contribution makes sense and times when it doesn’t, let’s explore.
When Your Earned Income is High Enough
A major benefit of the RRSP account is the immediate deduction and tax savings in the year of contribution. As each dollar contributed into the account is 100% deductible from your taxable income, the higher the income, the higher the taxes saved. For instance, a Canadian earning about $45,000 will get a tax refund of about 20% for each dollar contributed. Someone earning above $150,000 will expect a tax refund of about 40% for each dollar contributed. As the tax relief increases with the amount of reported income, meaningful tax benefits start to be realized at about $55,000 of income. Anyone who is making above this amount should be considering an annual contribution to their RRSP.
If you’re in the upper tax brackets of 44.97% to 53.53% with an income of $150,00 or higher, the deduction from an RRSP contribution and the resulting tax refund becomes extremely beneficial.
The wonderful thing about RRSP contribution room is it can be carried forward until age 71. If you are in a lower tax bracket today, such as a student or entry level job, it may make sense to wait and make a larger contribution when your income is higher. During the lower income years, the TFSA would be an appropriate account to provide tax free growth while waiting to use the RRSP.
When You have an Exit Plan
RRSPs can be amazingly effective tools for reducing taxes and accumulating retirement assets. However, to really unlock the benefits of the RRSP, you need a plan for the withdrawal phase, not just the accumulation stage. As the contribution to the RRSP are tax deductible, the withdrawals from your RRSP/RRIF will be fully taxable income. Under the current rules, an RRSP must be converted to a RRIF by age 71 and taxable withdrawals staring in your 72nd year. Then, starting in your 72nd year, you are forced to withdraw 5.4% of the account. This minimum payout percentage then increases each year with age.
For the RRSP to provide maximum benefit for Canadians, three things must occur.
- A contribution and deduction at a high rate of tax
- Tax deferred growth on the investments
- A withdrawal from the account in lower tax bracket in retirement.
Without a plan to exit the assets from the account in the lower income retirement years, you can find yourself painted into a corner of getting the funds out tax efficiently. Having a significant amount of assets remaining in your RRSP/RRIF at death is the worst possible scenario. In many cases, doing nothing and ignoring the assets accumulated in your RRSP will lead to this outcome. To avoid this scenario and utilize the back-end benefits of the RRSP, you need to develop a comprehensive financial plan that calculates your income in retirement. Once you understand your income sources from CPP, OAS, Pensions, and other investment income, you can then determine the optimal RRSP/RRIF to withdrawal each year. These funds are then taxed at a favorable rate while strategically melting down the assets throughout your retirement years. When done properly, this can be very effective strategy. Without a detailed exit plan, the death of a taxpayer can become a very costly event for one with a large RRSP.
When you don’t have a pension
If you’re fortunate to be involved in a defined benefit pension plan, you’ve shifted some risk of your retirement to the pension itself. Regardless of the performance of the underlying funds, you are still entitled to your annual pension benefits. Also, by being involved in a pension plan, you will be creating a pension adjustment which reduces or sometimes eliminates the ability to contribute to a RRSP. If you are not involved in pension plan three things are likely to be true. Firstly, if you are working and have earned income, you will be earning RRSP contribution room. Secondly, without a pension commencing at retirement, you will likely experience a significant drop in your income and tax rate upon retirement. This is the optimal tax scenario for the RRSP contributor. Lastly, you’re likely going to need the retirement assets for supporting your retirement. CPP and OAS provide only a basic level of retirement income. Building other retirement assets is strongly recommended for anyone without a pension. Not only does the RRSP provide a tax deferred account for retirement savings, but it also reduces the incentive to tap into these funds early. For these reasons, if you are not involved in any pension plan, you should have the ability, the tax incentive, and the need to build retirement assets in your RRSP.
While the RRSP can be incredible tax planning and retirement tool for most Canadians, you need to assess the following:
- Your current and future income
- Your pension involvement and retirement assets
- Your exiting strategy before committing to being an RRSP contributor
Thankfully, all of these components can be identified through a comprehensive and living wealth plan. It is recommended to start the planning process as early as possible because when you fail to plan, you plan to fail.
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