RRSP/RRIF

The proper use of RRSPs: The one formula approach

The proper use of RRSPs: The one formula approach

No matter what time of the year it is, one of the most popular questions I get is whether it makes sense to buy a RRSP? I remember coming out of University and my father telling me I should invest in RRSPs for retirement. When I asked him why, he simply said “You need to save for your future.”

Now after being in the financial industry for almost 30 years, I realize that there are a lot of people who bought RRSPs but don’t really know why. Most people buy RRSPs for the tax deduction to save tax immediately but that’s a little short sighted. There’s a little more to making good RRSP decisions than just getting a tax deduction. Remember that somewhere down the road, when you take the money out of the RRSP, you then have to pay tax right back to the government. So how do you know if you should buy RRSPs? How do you know if you are using RRSPs properly? How do you know if buying RRSPs is better than the Tax Free Savings Accounts (TFSA) or paying down debt?

Here’s my very simple formula to help you use RRSPs properly:

If your marginal tax rate (MTR) at the time of contribution is greater than your marginal tax rate at the time of withdrawal, then the RRSP will always give you a benefit.
 

So what does all this mean? Firstly, you need to know about marginal tax rates. Marginal tax is simply the amount of tax paid on an additional dollar of income. As income rises, so does the tax rate.

Marginal tax

For 2020, the tax rates for Alberta and Federal tax combined are:

Lower LimitUpper LimitMarginal Tax Rate
$0$12,2980%
$12,299$19,36915.0%
$19,370$48,53525.0%
$48,536$97,06930.5%
$97,070$131,22036.0%
$131,221$150,47338.0%
$150,474$157,46441.0%
$157,465$209,95242.0%
$209,953$214,36843.0%
$214,369$314,92847.0%
$314,92948.0%

Your marginal tax rate determines the immediate benefit for the RRSP. For example, if I made $25,000 last year, my wife made $50,000, and you made $100,000 and we each decided to invest $1000 into the RRSP, I would save $250 in tax, my wife would save $320 and you would save $360 in tax. Despite investing the same $1000 we all get different tax benefits depending on our marginal tax rate.

For marginal tax rates for provinces other than Alberta:

What will your marginal tax rate be when the money comes out?

Not only do you need to know what your marginal tax rate is at the time of contribution but it would be advantageous to do some projections to see what your marginal tax rate might be when you are going to take the money our of the RRSP.

Obviously, the ideal situation is to invest the money when you are in the highest marginal tax rate and then take the money out when you are in the lowest marginal tax rate. Let’s say, you are in a 39% MTR and you invest $1000 into the RRSP. The government gives you $390 as a result of that RRSP contribution. But the government does not really give you the money, they are lending you the money because when you take $1000 out of the RRSP, then you have to pay tax. But if you are in a 25% MTR when you take the money out, you do not have to pay back the $390, you only have to pay back $250. That’s a 14% benefit on top of any investment returns you may have made. That’s how to use the RRSPs properly and to your advantage.

On the other hand, you would be doing yourself a disservice if you put money in while you are in the lowest tax bracket and then taking it out in a higher tax bracket. Imagine putting in $1000 into the RRSP when you are in a 25% MTR but taking it out when you are in a 32%, 36% or 39% MTR. That’s giving the government more of your hard earned money.

How long before you draw money out of an RRSP?

In this equation for evaluating the use of RRSPs, I have not considered the compounding effect of the tax-deferred income inside the RRSP. When you make money on the investments, you do not have to pay tax on the growth as long as the money stays inside the RRSP. The more time you have, the more valuable tax deferral and compounding become. For example, someone who is young and just starting to work may not be in a high tax bracket. Although their best earning years are ahead of them and they may be in higher tax brackets down the road, I would argue that the compounding effect of a long term tax deferral outweighs the value of the tax deduction.

Related article: The power of compound interest

My advice to young people is to develop a long term savings habit by putting money into their RRSPs on a regular basis. Developing the habit of saving for the future instead of saving to spend is the best financial habit that you can develop.

As you can see, most Canadians will benefit from using RRSPs. The value of the RRSP is not only determined by the tremendous tax deduction at the time of contribution but also other factors like your marginal tax rate at the time of withdrawal, the investment return over time, what you might invest in (capital gains vs interest vs dividend income), etc.

In some cases, the RRSP will not make sense. In the end, the decision to buy RRSPs is a personal one. Ideally, the decision is made by developing a plan and doing some future income projection. Good luck!

Comments

  1. hijratali

    my income this year is $41615 my wife has only $1200 in UCCB we have three kids plz let me know as soon as possible that how much i should contribute to RRSP to get maximum tax return and also get maximum CCTB ,our combined income is$42815 my RRSP limit is $17000

    • Brian So

      Since your MTR is around 25%, you’ll receive $25 for every $100 you contribute. I would consider putting as much as you are comfortable with in your RRSP and investing the refund in a TFSA for easier access. You can even consider splitting your contribution between a your own RRSP and a spousal RRSP to equalize retirement income, which will lower tax. This is not as important since you are now allowed to split pension income in retirement.

    • Georgia

      UCCB is not considered income (since the last year!); With income as yours and in your family situation, I wouldn’t put anything in the RRSP. You are in a low tax bracket now and could be in a higher later. Save your contribution room for later and put your cash surplus (if any) into TFSA. Hope this helps!

    • rick

      YOUR INCOME IS BELOW 46,000. YOU WILL ONLY DEFER TAX AT 15%. I WOULD NOT CONTRIBUTE AND ONLY CONTRIBUTE TO BRING MY TAXABLE INCOME TO 46,000.00

    • Greg Dwyer CFA

      I think a tax minimization strategy would be as follows:
      Since you earn RRSP room as a percentage of Earned Income and since it accumulates if not used in any year. If we assume your final few years of income before retirement may be your best income years. I would save money in a TFSA to the maximum every year, invest that money conservatively and move it to an RRSP in my few years before retirement. The money grows tax free in the TFSA, you optimize tax savings, in your final years and reduce tax payable on the RRSP withdrawals, (assuming you tax rate drops in retirement).

      • Jo

        Greg, I’m confused. Why would you transfer tax-free money (TFSA) into a vehicle that makes it taxable upon withdrawal (RRSP)?

  2. Jane Savers @ The Money Puzzle

    I use this scale to decide how much to contribute and I prefer to add to my TFSA.

    I just can’t decide what to do with my return that I will save this spring. Debt, RRSP or TFSA? I always waffle and end up splitting the money.

    I do take the first $100 of the return to blow on stuff we never have money for like steak and new underwear.

  3. My Own Advisor

    Good post Jim.

    I’m a fan of RRSPs but prefer to focus (meaning, max out) my TFSA instead.

    Another point to consider, if you want to retire early, there is a greater chance your MTR will be lower at time of withdrawal than during your contribution years. In this regard, it makes sense to put some money into the RRSP today and let the laws of compounding do their thing as often as they can.

    Mark

  4. Adeem

    I do not mean to be a stickler, but there is no such thing as buying an RRSP as an RRSP is a type of account not an item to be purchased.

    • Brian So

      People say the phrase ‘Buy RRSP’ in real life though.
      I think the point is that this is a good strategy to follow, no matter what investment you have in your RRSP.

  5. Bet Crooks

    If you can delay the gratification a while, you can actually contribute to an RRSP while in a low tax bracket, and not claim the deduction till years later when you are in a higher tax bracket. It does mean you won’t get a tax refund until that later claim.

    This works best if you know you will be in a much higher tax bracket in a year or in a couple of years. For example, we have friends who knew that the wife would get a big bonus in 3 years when a delayed bonus would be paid to her at work. (She earned the bonus one year, but the company would not pay it unless she was still working with the company in 3 years time. Sneaky company!) So she knew in three years her tax rate would be higher as the bonus would make her skip up a tax bracket.

    She had already maxed out her TFSA though. She put the money in her RRSP to get the tax-free growth for the three years, then got the biggest tax refund she could by waiting to claim it.

    This might also be something to consider if someone is off on Parental Leave for most of one year (so low income, not a good tax refund for an RRSP contribution), have maxed out their TFSA and will be back at a high paying job the next year. They could contribute during the Leave year, but wait till the following year to make the deduction to maximize the tax refund.

    Either way, the important thing is to save it somewhere and not just spend it!

    • Bill

      you can over contribute to RRSP more than $2,000 at any time.

    • rick

      BE CAREFUL NOT TO OVERCONTRIBUTE BY $2000. THERE IS A 1% PENALTY PER MONTH IF YOU DELAY THE DEDUCTION

  6. will miko

    I was wondering if getting rrsps is right for me I made 120000 last year i have a full 25500 in my tfsa and have 9000 in contrabution room in my rrsps avail does it make sense to buy them

  7. will miko

    please email me a response in the question above ty

  8. Will

    The most important consideration not discussed is what the tax rates will be in the future! Do you think tax rates will go down? Not in my lifetime…… As governments around the world continue to print more and more money. Taxes can only go up! How far up is the question nobody has an answer for. I much prefer to max out my TFSA as it is not taxed when you make a withdrawal in the future. This is my number 1 priority. Anything left over goes between my cash account and my self directed RRSP account. The other important discussion is what to invest in……….. That is a whole different subject. I chose large cap blue chip that are way under value with a certain degree of certainty that they will be around for the next 100 years. Take for example BP oil. With a 4% dividend growing at 10% for the next 25 years.

    • will

      ty for the response i was thinking just that, investing in a self directed rrsp with one of the banks stocks or even large commucation stocks such as bell etc. and with the refund i recive i was going to put it into my wifes tfsia

  9. Will

    I am currently sitting at about 90% cash. I believe there will be a major correction aka crash within the next 2 years. There is no way things can continue to go up like they are with the fundamentals so messed up!! I highly suggest you read Rule # 1 by Phil Town. I would not just blindly buy any stocks right now. You must have a safety factor built in to your approach. I will not buy anything unless it is 50% below its intrinsic value. Sounds complicated but it isn’t. Phil teaches you how to do it. The real secret to investing is not losing money, ever!

  10. Tara

    Hello, I currently have 2 jobs which fall in the Quebec tax bracket 11,196-41,095 or 28.53% MTG. But every year I have to pay more back than someone who has 1 job. Sometimes my total income is below 41095 and sometimes it is above, if it is above the MTG jumps to 32.53%. So my questions is how do I make sure I put enough into my RRSPs, so I don’t have to pay back $1500 to $2000 to the federal and Quebec governments. Last year I earned $41000 and I put in $4500 and I still owed Quebec $350. I got back $450 from federal. Is there a general rule of how much percentage of my income I should be contributing? Normally for those with 1 job they would contribute at least 10%.

    • Mary

      Tara, when people have one job, the HR people for the company know how much the person makes and bases the tax deduction on the amount of their pay. When someone has 2 jobs, it is up to you as the employee to monitor the tax rate. If you do not want a big refund every year, you can do a TD1 form (I think that is the form number) with CRA and have one of your employers deduct a different amount. The CRA website has information or the HR people can help you. Some people like having a tax refund.

    • San

      One thing Jim did not mention or I missed reading it? That is the case if we died before having the chance to withdraw a big portion from our RRSP, then whatever left in RRSP will be added a whole chunk to our final tax return. Imagine someone put in RRSP as soon as being out of school, by the time the person reaches 65 his/her RRSP account must be big with 6 digits from the contributions and interest compounded in more than 35 years!. Let say after two years withdrawBig some from RRSP the person is gone from this life; then what left in RRSP will be taxed at the top tax bracket for sure! In that case CRA lent him $39 and now take back $51, not only on the contributions he made but also on the compounded interest! CRA win big! Don’t they?
      The trick to withdraw from RRSP is that if you take small amount each year to avoid of paying high tax, big balance left in there if you died will hit a much higher tax bracket anyway. If you try to withdraw a good amount so that your RRSP account is soon depleted to avoid high tax when you die, you then will hit a higher tax bracket now, not yet to say to be crawled back from OAS. I am truly in this current dilemma

  11. Shirley

    Hello, and thank you for the advice. This explains a lot for me. I do, however, have a question about the tax-free savings accounts: I am almost 40 and I have not yet invested in RRSP’s, is a tax-free savings account a better option for me? Also, you didn’t get into tax-free savings accounts but you did mention them, what would make them a better option than RRSP’s? And do you happen to have an article that could provide me with more information on this?
    Thank you again and have a wonderful day,
    Shirley

  12. Marlon

    Would I make more money investing in stocks or rrsps at the age of 33? With putting in 500.00 yo start at 50.00/month.?

  13. Peter Anderson

    if i invest $150,000 in my RRSP, would i get very good cheque back from Taxman. ?? ( I do have that much room ) notice of assesment tells me that,every year thanks

    *Salary approx $36000/yr

    *This large amount from sale of home

    • San

      Based on my experience as a retiree with an RRSP account maxed out contribution limit I would say, at your annual income level, I would not put &150,000 in the RRSP.. Use up your room in TFSA; then put some in RRSP, $36,000 as your salary; then take your whole year tax refund to have a nice trip, Though we have to save for the future, but life we never know, so don’t overlook the enjoyment when you are still able to do it. You can put another lump sum into your RRSP the following year. Because if you put a whole amount of $150k in RRSP at once, the tax refund you can have is only on the $36,000 income.

  14. Nickia

    So currently I am 24 years making like 28 000$ .. what is a good amount to contribute to my rrsp? What should I look for when getting an account?

    • Paul

      Hi Nickia
      At your age and income level the RRSP makes ZERO sense.
      The TFSA is a much better and more flexible alternative.
      At your age, your financial priorities should be
      1) pay off the credit cards and all personal debt.
      2) purchase the home you live in. In the long term, this is the best tax free Canadian wealth builder.
      3) pay off the mortgage.
      4) then look to the TFSA.
      5) only then look to the RRSP.
      This financial plan worked well for me and my children.
      Good Luck!

  15. MJ

    Great post, thanks! But the section titled “What will your marginal tax rate be when the money comes out?” doesn’t actually answer this question. Can you provide more details please? thanks!

  16. SPProService

    The post makes a lot sense! Thank you for good information. However one important part to be taken in consideration – the unofficial inflation rate. I mean how much actually the cost of living and the housing will rise. Remember, while your savings are tax sheltered, they are not protected against the ever rising costs. You will have much more by the time of your retirement, but will be able to buy much less. Therefore only extra income should be saved to RRSP.

  17. Marsiyela

    Hi, I am a new immigrant and would want to start investing. I am in the midst of trying to get familiar with all the Canadian financial lingo. As a starter like me (age 34, single), my projected gross annual income will be between $28,000 – $30,000 (depending on the hours rendered), what can you recommend for me to start on with? RRSP or TFSA or other investment tool? Please help. Thank you very much.

    • Paul

      Hi Marsiyela,
      At your age and income level the RRSP makes ZERO sense.
      The TFSA is a much better and more flexible alternative.
      At your age, your financial priorities should be
      1) pay off the credit cards and all personal debt.
      2) purchase the home you live in. In the long term, this is the best tax free Canadian wealth builder.
      3) pay off the mortgage.
      4) then look to the TFSA.
      5) only then look to the RRSP.
      I am also an immigrant, but twice your age. This financial plan worked well for me and my children.
      Good Luck!

  18. jdji

    You have to be Canadian Citizen to open a RRSP. A person determined to be a non-resident of Canada for income tax purposes can hold a valid Social Insurance Number and be allowed to open a TFSA, however, any contributions made while a non-resident will be subject to a 1% tax for each month the contribution stays in the account. For more information see Non-residents of Canada.

  19. Chris Reed

    Sorry but I dispute some of your claims. Yes I agree that there is a possible Bonus (or Penalty) from withdrawals at tax rates lower (or higher) than at contribution. And I agree that this Bonus/Penalty = $draw * change in tax rates. My diagram shows an example of a 10% drop in tax rates creating a $1,297 bonus. https://www.dropbox.com/s/0u3j6vv59gzperr/RRSPbenefit.gif?dl=0

    The problem is when you go on to claim that profits earned inside are only tax-deferred until withdrawal. In fact profits are always PERMANENTLY sheltered. On the diagram you can see the resulting $1,165 benefit that will always exactly equal the same permanent benefit from a TFSA.

    The idea that profits are taxed on withdrawal is a false conceptual model that ignores the tax effect of the original contribution. It will always exactly equal and offset what your conceptual model calls the ‘benefit from deferral’. This is the $2,391 number in the diagram.

    Another problem that really needs to be quantified for people, is the cost of 50% GIS clawbacks. When there is no other personal income, the first $10,000 or so of RRIF draws will be taxed at 22.5% + 50% = 72.5% tax rates. See diagrams of typical retiree at http://www.retailinvestor.org/images/incomeInRetirement.png

    Since the median value of RRSP accounts at age 65 is about $200,000, that $10,000 withdrawal is about average. And 72.5% tax is larger than EVERY regulatory tax rate for contributions, so piles of people will pay the Penalty and not get the Bonus they expected from having a lower income in retirement

  20. Kelly Ann Mulholland

    I just retired. Throughout my working life(municipal employee) I put away enough money into RRSP’s to give me a tax refund that would pay for my vacation. I didn’t know or think about the future or investing. I consider those vacations to have been an investment in my future, I worked in one of the most stressful of the emergency response fields. Life is more than the future after all.
    Now at retirement I have just less than 90k in rotating RRSP GIC’s. I now know I should have put all of my RRSP’s in Omers AVC’s that have been historically earning 11%. Oh well, now it is my pleasure to figure out how to remove them without incurring to much tax. I intend to defer my CPP for all the years I need. I followed your site for all of my retirement year but wish I had found you sooner. Thanks for great information.

  21. Leonila

    Repost:

    I don’t know if my comment appeared here.

    We have a spousal rrsp. As of June, I estimated my husband YTD in December this year will be around $93,000. His the one only contributing as I don’t have permanent income each month. And our spousal rrsp room is $26000. He also has contribution of $2 each hour he works that goes to rrsp. We wanted to put extra contribute up to $9000 within 6 months starting June since we haven’t put anything yet this year.

    How much tax we pay next year? Or estimated tax credit to received then?

    Does it has to be $1500 monthly to reach $9000 or it doesn’t matter how much I put each month/pay check to reach $9000 within 6 months?
    His automatic contribution base on his hours is $2 x 160hours=$320x 6months is $1920.

    $1920 + $9000 is $10920 correct? Which leaves us more room still for our rrsp of this year?

    Looking forward for answers.

  22. Nancy

    I will be 65 in April and already retired. What is your advise on: Have approximately 50 thousand in RRSP was wondering should I cash them in before the government puts them into a rrif at age 71?

  23. Richard

    Great post. Question on RRSP withdrawals. Let’s say someone saved a ton into their RRSP and now have $800,000. They are also an early retire – say 50 years old, so they have no income from a paycheck.

    Assuming a 5% return, should they let their RRSP grow to take advantage of tax free compound interest until mandatory withdrawal kicks in at 71? Or should they spread their withdrawal out over the next 30-40 years (say $50K / year) to minimize taxes?

    If they let it grow, at 5%, their portfolio could reach $2.5M at 5% by the time they are 71. At that time minimum withdrawal would be 5.28% of the portfolio or $132,000, which would put them in the 38% marginal tax bracket for Alberta. It would only go up from there.

    If they spread it out by taking $50,000 each year over 30-40 years, they are in the 30.5% marginal tax bracket, but the money they remove from their RRSP would not grow tax free. $50k / year with a 5% return should be enough to deplete the RRSP in about 30-40 years.
    Assume this money is not needed to fund their lifestyle, but will just be invested in a non-registered account with the same 5% return.

    Which approach is more cost effective in the long run?

    Thanks

  24. Brian Moylett

    Hi, what are your thoughts on principal protected, equity linked investments for RRSPs and TFSAs?

    Wisdom Structured Investments currently have an investment offering that:
    – Protects your principal;
    – Tracks the S&P/TSX 60 (top 60 companies on TSX);
    – Gives 2:1 leverage, meaning the investor earns returns on double what they invest upfront; and
    – does not charge annual management fees

    https://www.wisdomsi.ca/

  25. A, Dandia

    Hi: Jim Yih
    I am interested for the following topics:-
    (1) CPP benefits (maximum), early claim at age 60 (penalty), disability pension
    (2) OAS benefits and claw back rules
    (3) GIS Rules- eligibility survivor benefits

  26. D Kruse

    When comparing the MTR at the time of contribution to the MTR at the time of withdrawal, should one use the “total income” or “taxable income” when determining the MTR in both cases?

  27. Dett

    Hello? Can anyone answer my question above?

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