RRSPs for Huge Tax Savings When Retiring Early

Edited Photo. Source: Flickr - Martha Soukup

Normally, being a gilded public employee with a decentish DB pension plan, I would say it's not ideal to contribute to RRSPs first. After Monday's post, you can see how a fully taxable pension income and massive RRSP income is a recipe for tax disaster.

If I contribute the max to my RRSP after the Pension Adjustment, I would be able to stuff about $6,000 a year in there. Do that from the time I'm 25 until I'm 65 and I've got a $1,000,000 RRSP account that churns out $40,000 - $50,000 a year.

Throw in my pension of $75,000+ after 40 years of service to my community and I'm getting taxed at some ugly rates. After all sanity lost during 40 years of this work, I'm grimly staring at OAS clawbacks, RRIF mandatory withdrawals in 6 years time at age 71, and huge tax bills.

Fortunately there's another way. If my spending is low I can still max my RRSPs (and TFSAs of course), collect the juicy tax return at higher rates now, and pay super low tax rates on withdrawals later.

Enter early retirement...

Cutting That Tax Bill Waayy Down

Early retirement to me means retiring before the age of 60. At 60 we can receive CPP payments and other seniors benefits, so not really special to me. When you retire before 60, you must be able to live off your investments because nothing else is coming in.

This also means you have full control over your tax situation and can use this to deplete your RRSP at low tax rates. At withdrawals under $25,000, your effective tax rate is around 10%. Add in some Canadian dividend income from your Cash/Margin Account and your tax bill can actually be reduced in many provinces!

Example Case

Let's pretend I'm single, earn a flat $100,000, live in BC, and don't contribute to a pension plan. I spend $40,000 a year. At my salary level, I can contribute 18% to my RRSP plus $5,500 to my TFSA plus $16,500 to my Cash/Margin Account.

As soon as I meet the 30x Rule, I am going to pull the plug. If I invest in the RM Balanced Portfolio which returns 6% annually after inflation over all those years, it's going to take me 18 years to save. I start saving at 27 years old so I retire from work at 45 years old.

At 45 years old, my RRSP will be worth $581,000, my TFSA will be worth $177,400, and my Cash/Margin will be worth $480,200 for a total combined value of $1,238,600. At 30x this will generate $41,266 a year. My Cash/Margin account holds ETFs that pay $14,000 in Canadian dividend income each year.

In B.C., I pay negative tax rates on the Canadian dividends up to $45,900 total income. I want to deplete my RRSPs first, so I will set up my account to withdraw $26,000 annually from my RRSP ($40,000 spending - $14000 dividend income). I will pay just $2,165 a year in tax on that income (5.4%).

To cover the tax liability and maintain my $40,000 spending level, I can withdraw some money from my Cash/Margin account and realize some Capital Gains Income which is likely to be very minimal as gains only make up about 1/3rd of each withdrawal (the rest is taking my contribution back).

By using this strategy, I was able to turn a 35% tax return on my contributions to a 5% tax on withdrawals later. A huge tax savings! During my working years, I reinvested the $6,320 tax refund. This sped up my retirement by about 2 years--or more than 10% thanks only to tax savings.

Again, it's even more efficient when you're married or CL as you can set up a Personal and Spousal RRSP to split income very evenly and keep taxable income low as well as contributing to two TFSA accounts instead of one. Come back Friday for a write up about the importance of sharing finances in relationships.

2 Replies to “RRSPs for Huge Tax Savings When Retiring Early”

  1. I’m curious about this strategy. As a public servant with a decent pension plan I always thought saving was ridiculous until I discovered MMM and the opportunity to retire early. My wife also has a decent DB pension, we’ve been saving into RRSP to save on the tax bill at the end of the year. We plan to contribute to our TFSA once we run out of RRSP room then pay off the mortgage. When we retire early we would use the RRSP to fund retirement until the pensions kick in. Would you push the CPP withdrawals to a later time for the bigger payout?

    1. Mr. Rich Moose says: Reply

      It’s important to point out that this post is not about filling RRSPs before TFSAs. It’s about not being afraid to fill both to the max if you can and not being afraid of RRSPs just because you have a good pension.
      Stuff the TFSAs first. When you contribute to a decent pension plan, you are generally at least doubling up your RRSP contributions as it is. However, it is being invested in a lower return, but (more or less) guaranteed portfolio. You can almost think of it as a big fat bond. You can always work on that RRSP room to make a nice payment “bridge” later.
      Deferring a pension depends on the plan. Is it being indexed while you defer, how long do you have to wait, and would the 25x return on the invested commuted value be better than the expected pension?
      CPP withdrawal issues are as much a health question as a financial question. I might dig into this a bit more in a future post.

Leave a Reply