Many Canadians think they should invest in their RRSPs every year, without exception.
But the truth is, there are situations where it's actually disadvantageous to contribute to your RRSPs - and there are likely more financially savvy ways you can invest your money in these circumstances.
In this piece, we'll look at the two biggest considerations for investing in your RRSPs, and what you can do if it's not the right option for you.
1. How RRSP contributions affect your taxes
The first reason for not contributing to your RRSP, or at least not now, would be for tax purposes. You’ve likely been told about the tax benefits of investing using a Registered Retirement Savings Plan (RRSP). The basics of the plan are that your ability to contribute is determined by your previous year's earned income (18% to be exact, up to a maximum annual amount).
Once you have contribution room available, you can open an RRSP and make contributions up to that limit. Those contributions are then deducted from your taxable income in the year that they were made (including the first 60-days of the following year). Assuming, you’ve paid enough payroll tax, you should get a refund on your tax return. Seems like a no-brainer. RRSPs also serve as a valuable way to save for your first home, allowing you to borrow a down payment of up to $35,000 tax-free from your savings.
However, we need to consider some other factors. RRSPs are not truly tax-free savings vehicles, like a Tax-Free Savings Account (TFSA). They are merely deferring tax to a later date, usually retirement. This is still a good thing, it’s just that when the funds are eventually withdrawn, every dollar is taxed at your marginal tax rate (your highest rate). So, the idea is to contribute while in a higher tax bracket now and withdraw the funds in a lower tax bracket later.
Making sense of tax brackets
If you’re just starting out in your career, you may not find yourself in a high tax bracket. And when your income is low, you won’t be getting all the potential benefits of the tax savings by contributing to your RRSP.
For example, if you live in Ontario and earn $60,000 annually, with a marginal tax rate of 29.65%, a $3,600 RRSP contribution ($300/month) will only save you $1,067 in tax.
Meanwhile, someone earning $120,000 annually, with a marginal rate of 43.41%, will save $1,563 – a difference of 46% more tax savings on the same contribution.
For some, a higher income may not be achievable in the near future, or at all, in which case you would want to consider what your retirement income would look like. If you would likely have a lower marginal tax rate in retirement, then it still might make sense to contribute.
One last thing to consider is whether additional income in retirement could affect your eligibility for certain income-tested retirement benefits as all RRSP withdrawals are considered taxable income, which could reduce your benefit entitlement or make you ineligible.
2. How you will withdraw your funds
Another reason you may want to avoid investing in your RRSP is its lack of flexibility. There are many positive aspects to RRSPs, but also a few key drawbacks:
You can’t access the funds without being taxed*
You lose your contribution room - forever.
*Notable exceptions would be using the Home Buyers Plan (HBP) as a first-time homebuyer, and the Lifelong Learning Plan (LLP) to pay for education.
This also means that an RRSP is not suitable for short-term savings or as an emergency fund. Thinks of it like this: you only want to put money in your RRSP that you’re comfortable not touching until retirement.
When a TFSA makes more sense
With the advent of the TFSA, you now have the option to save money that is truly tax-free and possibly utilize an RRSP when it’s more advantageous. Once you turn 18 you will begin to accrue TFSA contribution room – which is the same amount for everyone and is indexed to inflation each year.
Contributing to your TFSA won’t allow for any income tax deduction come tax time, but it does provide more flexibility. In addition, when making withdrawals, there is no tax to be paid on any investment returns and no amount is added to your income.
Even better, the contribution room from any withdrawals will be returned to you the following January 1st. So, whether you’re creating an emergency fund for the next financial disruption, saving for a new car or some other short-term goal, a TFSA may be a better option.
While RRSPs have long been considered the defacto tax-advantaged savings plan, TFSAs are also extremely valuable financial planning tools. It’s not a one-size-fits-all situation and these are just a few of many considerations when looking at what is in your best financial interest.
It’s important to sit down with a professional who can discuss this in more detail to determine what is best suited for you and your specific financial situation.
Remember, if you do decide to contribute to an RRSP for 2021, the deadline to do so is March 1st, 2022.
If you're unsure whether or not you should be making RRSP contributions, book a free 30-minute consultation to find out what makes the most sense for you.