Proper Ways to Use RRSPs

With the March 1, 2018 deadline for RRSP contributions (attributable to 2017 income) fast approaching, let's do a quick review of who should use RRSPs and how to maximize their tax advantages for different purposes.

RRSP Basics

First, it's important to understand what RRSPs are and how they work. An RRSP is a special type of savings account that carries certain tax advantages. RRSP accounts are different from TFSA accounts and non-registered (Cash/Margin) accounts.

You must look at your income tax situation to determine if RRSP accounts should be part of your savings plan. Contributions to your RRSP are deducted off your taxable income. This reduces your income tax owing on your income.

On the other hand, withdrawals from RRSP accounts are taxed as regular income. Any gains or losses on investments that remain in your RRSP account are not reported on your income taxes.

Since RRSPs can be quite lucrative—particularly for higher income individuals—the government has decided to cap contributions at 18% of pre-tax income to a maximum of $26,010 in 2017 (don't want people saving too much I guess). Hopefully one day the government will reform and simplify our tax system so we don't need to deal with special accounts and this limit nonsense; I'm not holding my breath!

If you earned $100,000 in 2017 and contributed the maximum $18,000 to your RRSP, you would only be required to pay income tax on $82,000 for the year instead of the whole $100,000. However, years down the road when you withdraw that $18,000 plus the investment gains earned on that money, you will claim that as regular income and pay tax on it at that time.

In a nutshell, RRSPs do not always save you tax, but they always defer taxes to a later time. To meaningfully save tax, you must contribute to your RRSP accounts when you are in a high tax bracket (earn a high income) and withdraw money from your RRSPs only in years where you are in a low tax bracket (earn a low income).

Good Scenarios for Using RRSPs

I think it’s generally good practice to always try put money into your RRSP—especially if you earn income that’s higher than the second tax bracket (more than $90,000).

For most people this means they should fill their TFSA first and their RRSP accounts after that. (There are some exceptions to this for high spenders or very low earners.)

Standard Retirement Savings

RRSPs are a decent tool for retirement savings. In retirement, you almost invariably earn less taxable income than when you are working. This is because your spending is likely to be lower and you only need to withdraw the funds you require to pay your daily expenses. You no longer need to pay for savings, or work-related expenses. Researchers estimate Canadians spend 20-40% less money in retirement compared to when they are working.

You can also split RRSP income with your spouse, further assisting you in staying in the lower tax brackets. You can do this with Spousal RRSPs or under the current pension income splitting rules when you’ve converted your RRSP to a RRIF.

At some point you must convert your RRSP to a RRIF (age 71 at the latest). After the conversion to a RRIF, you can no longer contribute to the account and you are required to make minimum taxable withdrawals from your account each year. These withdrawals grow year after year and can put individuals with very large RRSP/RRIF accounts into very high tax brackets. It could also result in claw-backs of seniors benefits ranging from Old Age Security to prescription benefits.

If you are using RRSPs for retirement savings, be careful you don’t let your RRSP accounts become too big! Even $1 million per person is probably too big for most people.

Sabbaticals / Stay-at-home Parenting

RRSPs are a great tool to save for sabbaticals. In our society, especially the younger generations, it is increasingly unlikely that you will work the same job at the same company for your entire working career. Taking sabbaticals between career changes is a growing trend.

This is for a few reasons: people are finally doing something to combat boredom at work, job markets and solo entrepreneurship have been relatively robust, the traditional loyal employer-employee relationship is breaking down, and employee benefits are slowly being cut which reduces the golden handcuff effect.

More and more people are refreshing themselves and their careers by taking sabbaticals. It generally means taking a year or two off work to reset your life. On sabbaticals people might travel, go back to school, develop a plan to start a business, spend time with kids, or fulfill any other passion.

Naturally, during a sabbatical, you are probably not going to earn much income. For this reason it’s a great time to withdraw some money from your RRSP at very low tax rates.

If you are planning a sabbatical in your future, save for it by contributing to an RRSP now when you are earning a higher income and use the tax savings to pay for part of your sabbatical.

This same principle applies to stay-at-home parenting. If you are planning on having kids and want to stay at home for a few years to raise them, you can use RRSPs and Spousal RRSPs to both save now while you are working. Then, the stay-at-home spouse (and Spousal RRSP beneficiary) can deplete the RRSP accounts at low tax rates while they are home. I talk more about that in this post.

Adult Education

Along the theme of sabbaticals, RRSPs are also fantastic tools to save for further education. You can use your RRSP to pay for school expenses and living expenses while you are going to school. If you are going to school on a full-time basis, you can also take advantage of the Lifelong Learning Plan (LLP).

The LLP lets you “borrow” up to $10,000 per year, or $20,000 total, from your RRSP to pay for your education. While you must be enrolled in school full-time, the borrowing use is not limited just to tuition or related direct education expenses.

The LLP is great because you do not pay any taxes on the withdrawals! The only catch is that you must pay money back into your RRSP once your education is finished. This repayment is typically done by paying back 1/10th of your total LLP borrowing over 10 years.

If you need more than $10,000 a year while you are in school, you simply make a standard RRSP withdrawal and pay tax on it. Again, your tax rates are likely to be very low if you’re going to school full-time so it's a great way to use tax savings to fund your education costs.

Home Downpayment

When it makes sense for you to buy a house, you can use your RRSP to fund part of the downpayment for the house purchase. The Home Buyers Plan (HBP) let’s new home buyers “borrow” money from their RRSP as a downpayment if they have not owned a house in the prior four years.

The HBP limits your withdrawal to $25,000. However, as with the LLP, your withdrawal is not taxable. This is an excellent way to get money tax-free out of your RRSP and use before-tax money to pay for your house.

HBP borrowing from your RRSP must be repaid over 15 years, starting the second year after you pulled the funds out of the RRSP.

Early Retirement Savings

The RRSP is a fantastic savings account to use if you plan to retire early. Generally people can retire early only because they spend a lot less than they earn. This often means above average income combined with below average spending (a perfect combination for tax arbitrage).

Since RRSP contributions save you money on taxes during your higher-tax income earning years, you can get a big boost by putting as much money as you can into your RRSP when you are employed.

The size issue of having a large RRSP is not a problem for early retirees. If you retire at 50 years old instead of 65 years old, you have given yourself an extra 15 years to slowly whittle down your RRSP before those mandatory RRIF withdrawals kick in.

Since your expenses are likely to be low, your RRSP withdrawals should be at low tax rates. RRSPs are much better than TFSAs if you are contributing at a 40%+ tax rate and withdrawing money at a 15% tax rate.

RRSP Pointers

  • Don’t be afraid to invest aggressively, within the limits of your risk tolerance, in your RRSP accounts. Contrary to some popular misconceptions, RRSPs are not just for bonds or low-growth investments. Total net worth is what counts!
  • Don’t ignore RRSPs because of bad information. RRSPs are much better than saving in a non-registered investment account for the vast majority of Canadians. Chances are you are in that majority.
  • If you make RRSP contributions throughout the year, use a form T1213 to get less tax deducted off your paycheques now and increase your savings all year.
  • Always invest your tax refund! If you don’t invest the tax refund from RRSP contributions, you are taking away the benefit of saving in an RRSP. Tax refunds should be viewed as a temporary loan from the government that you must pay back at some point.
  • Take a serious look at Spousal RRSPs. While current income splitting rules allow you to split any RRIF withdrawals with your spouse when you are a senior, it is a rule that is easily changed. If you earn substantially more than your spouse, or one of you has a defined benefit pension, Spousal RRSPs could be your best retirement savings option.
  • As with all investment accounts, choose a low-cost option like ETFs in a self-directed RRSP account. Managed RRSP accounts and RRSPs with the bank or life insurance company typically come with high fees in their products. These high fees can severely reduce your return on investments over your investment lifetime. You should never, ever pay more than 1.0% of your investment asset value in total fees!

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RRSPs for Huge Tax Savings When Retiring Early

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

After the Pension Adjustment, I would be able to contribute a maximum of about $6,000 a year in my personal RRSP. If I do that from the time I'm 25 until I'm 65, I've got a $1,000,000 personal RRSP account that will generate $50,000 a year until I die.

Then add 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, big mandatory RRIF withdrawals when I turn 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 Way Down

Early retirement to me means retiring before the age of 60. At 60 years old we can collect 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 time to deplete your RRSP at relatively low tax rates. If your RRSP withdrawals are under $25,000 per year, 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% of my gross income 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 a Growth/Balanced Portfolio (around 6% annual returns after inflation) over all those years, it's going to take me 18 years to save enough for retirement. 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 in safe income each year. We'll estimate my Cash/Margin account holds ETFs which 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). On this income, I will pay just $2,165 a year in tax (5.4% blended rate).

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 one-third of each withdrawal (the other two-thirds is taking my contribution back).

By using this strategy, I was able to benefit from a 35% tax return on my RRSP contributions while paying just 6% 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 common-law as you can set up a Personal and Spousal RRSP to split income very evenly and keep taxable income low. You also benefit from contributing to two TFSA accounts instead of one.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.