When it comes to RRSPs, it’s important to understand the difference between when you make your contribution and when you make your deduction.
What’s important to know about your RRSP contributions is that you have a limit as to how much you can contribute. Revenue Canada says your limit is 18% of your previous years income less your Pension Adjustment (PA) plus any past unused RRSP contribution room. The easiest way to figure this out is to look at your Notice of Assessment.
Related article: How much can I contribute to a RRSP?
Even if you make a contribution to the RRSP, you do not have to use it as a deduction right away. You might want to save it for a future year when you will be in a higher tax rate. A great way to look at this is through an actual case study I experienced recently.
Recently I met Jack who worked in sales at a medical supply company. He was getting a bonus of $10,000 and wanted to know if he should put that money into RRSPs. In order to answer the question properly, it’s important to take a step back and look at this from a bigger picture perspective. Far too often people make financial decisions based on their circumstances now without looking ahead into the future. After all, planning is simply looking ahead into the future to make the future as predictable as possible. Let’s look at some of his data:
In 2015, Jack made $85,000 in salary and earned a $1500 bonus. For 2016, Jack got a raise and will be making $90,000 in salary. In February 2016, Jack is getting a $10,000 bonus based on his sales in 2015. But because he is getting the bonus in 2016, it will be added to his 2016 income and not his 2015 income. His total income for 2016 is projected to be $100,000 compared to $86,500 in 2015.
If Jack does not put the bonus into RRSPs he can expect to pay about 4340 in tax and then keep the rest. If Jack puts the $10,000 into RRSPs, he can use that contribution as a deduction to avoid the tax now but he needs to watch the timing of the deduction. If Jack contributes the $10,000 into the RRSP in January or February of 2016, he can either use the tax deduction against his 2015 income or his 2016 income. If he uses the deduction for his 2015 tax return, he will only save $3390 in tax because he had lower income in 2015 and therefore was in a lower marginal tax bracket. the other issue to be aware of is that if he uses the tax deduction in 2015, then he may owe money in taxes when he files his 2016 return in April 2016. When he files his 2016 return, he has paid tax on the $90,000 of salary but he did not pay tax on the $10,000 bonus and he will not have a $10,000 deduction to offset it because he took the deduction in 2015.
When Jack was given this information, he still wanted to use the tax deduction now because the tax refund would help him buy a brand new racing bike. My advice was to save the refund to pay for the tax he will owe later but I’m not sure I was overly convincing. He figured he just had to work hard to get another bonus and that next year’s bonus
The case study simply illustrates that when making good RRSP decisions, it’s important to look at more than just your current circumstances. Take a spreadsheet and put in your own numbers. You might find that it’s better to save the RRSP deduction for the year ahead.
What would you do if your were Jack?