A lot of articles this time of year encourage you to buy RRSPs. In fact, the RRSP is one of the best tax planning strategies available to Canadians. However, there are increasing critics of the RRSP because while you may get tax benefits on the way into an RRSP, you have to eventually pay the tax on the way out.
That being said, about 80% of the time, the RRSP makes sense. So what happens the other 20% of the time? When does it not make sense to buy RRSPs?
Know your marginal tax rates
I’ve always stressed the importance of knowing what your marginal tax rate is when it comes to RRSP planning. The reason is the deduction you get is based on what your marginal tax rate is. For example, if you make $50,000 per year, you are in a 32% marginal tax rate (Alberta plus Federal rate). If you make a $1000 RRSP contribution, you will save $320 or 32%. The higher the tax bracket, the bigger the tax savings. The lower the tax bracket, the lower the tax savings.
You also need to know your marginal tax rate at the time you take money out of an RRSP. In the same example, if your income is $50,000 and you take $1000 out of an RRSP, you would not get $1000. In fact, you would only get $680 because you would have to pay 32% in taxes.
What’s the ideal situation for RRSPs?
The ideal scenario is to put money in when you are in a high marginal tax rate (40% for example) and take it out when you are in a low marginal tax rate (23% for example). In this example, you would be ahead by 17% just because of tax planning. On the other hand, the worst situation is to put money into an RRSP when you are in a low marginal tax rate (23%) and take it out when you are in a high marginal tax rate (40%). In this situation, you would be losing 17% due to poor tax planning.
When should you not buy RRSPs?
- If your income is too low and you will not benefit from the tax deduction. Generally this is about $10,000 of income.
- If you will be in a higher tax bracket in retirement than when you are working. It’s rare, but it happens. For example, Martha owns her own business and spends next to nothing. She reports personal income of $33,000 per year. As a result of being a saver, she has accumulated $750,000 in RRSPs, $500,000 in investments and her business is worth at least $1,000,000. Her retirement income will be greater than $33,000, especially if she does not start spending some of her money. Martha should not buy RRSPs.
- If you have too much money in RRSPs. Some people just have too much success in their RRSPs and should not buy more. For example, George worked in the tech industry at the right time. His RRSP grew to over $1.5-million, mostly because he had stocks like Nortel and Microsoft and sold most of them at the right time. He now has a tax liability because he will have to pay tax on all the money earned. There is no point putting more into RRSPs.
- If you might be in a higher tax bracket in the near future, an RRSP contribution works as a tax deduction against your income. Any deduction saves you money in tax equal to whatever your marginal tax rate is. For example, in 2004, Betty earned $33,000. She expects that her income in 2005 will rise to $38,000 because she is working in a new job. The tax bracket cutoff (where you move from one bracket to another) is $35,000. If Betty claims a $1,000 contribution in 2004, the deduction will be worth 25 per cent. If she waits until 2005 to claim the contribution, she will save 31 per cent in taxes (because she is in a higher tax bracket).
While these situations are not the norm, they do happen from time to time. It is just as important to be aware of the situations where an RRSP may not make sense as knowing when it does make sense.