Welcome back to the Jedi Academy. This is where we receive more advanced RRSP training. It is not for the uninitiated. For the basics of RRSPs, check out RRSP Anatomy 101 first.
In our last lesson, Master Yoda showed us how to use the Force in our RRSP to power up our TFSA. That strategy helps divert tax money from the Sith Lords and keep it in the pockets of your Jedi robes.
Ah, but be careful. The Sith are not that easily defeated. While they usually use brute force rather than Jedi mind tricks, they can also use some deceptive tactics. If you are aware of them, they are easily avoided.
The astute among you may have noted that the RRSP refunds estimated by my RRSP Refund Calculator are slightly lower than what some calculators on the internet produce. No generic calculator is perfect, especially with taxes. Mine included. However, in this case there are reasons for the difference and practical implications for you to avoid the path to the Dark Side.
The main issue – not all of your RRSP refund may be at your top marginal tax rate.
For example, you have an income of $92000/yr and contribute your max $16500 to your RRSP. You live in Ontario and look up your top marginal tax rate as 43.41%.
A simple calculation of your refund by multiplying $16500 by 43.41% would show your refund to be $7162. Of course, that makes you excited because you are going to use that money to top up your TFSA and have some left over.
Your euphoria is short-lived as my calculator out an estimated refund of $5564. Drat, there goes your plan to compromise with yourself and use $5500 to top up your TFSA and spend the rest. Bye-bye new iPhone 🙁
What happened? As you claim your RRSP deduction, it can lower your refund rate.
The first $200 results in a 43% refund. Then you drop into the next tax bracket of 38% for the next $4250. Then you drop into the 34% bracket for the next $3150. Then you drop into the 31% bracket for the remainder of your contribution. That means your refund is really 10% lower than what would be predicted using your top marginal rate. It means that the actual average marginal tax rate of your refund is 34%. Not 43%.
As you can tell by the reaction of Supreme Chancellor Bill and his Sith apprentice, this is not good for you. Why?
RRSPs are a tax deferral vehicle.
The RRSP tax refund essentially means that you are able to invest with pre-tax dollars. So, you start with more capital. Further, the investments grow tax-free in an RRSP. However, you will pay full income tax on the principal plus profits when you access the money.
All RRSP growth from investment income, whether capital gains or eligible dividends, are all taxed at the higher regular income tax rate upon withdrawal. So, even that is really tax deferral. Tax deferral is still advantageous because it gives you more money to start with. That increases the effect of compound returns over time.
An RRSP could result in an overall tax rate increase or reduction.
If your refund is at a rate of 34% when you put money in and you are in a higher tax bracket than that when you take it out, then you pay more tax overall. This could happen if your income and lifestyle increase over time at a rate greater than inflation. That is a probable and desirable outcome for most professionals.
The overall tax burden could also rise if the government increases marginal tax rates in the future. Impossible? The top marginal rate in Ontario was 48% five years ago and is now 53.53%. No one knows what the future holds, but I doubt it is lower government cash requirements.
This is an especially good trap for young professionals given their income trajectory.
The basis of this trap is that they have several years in a relatively low tax bracket and then a huge jump in income and tax rate.
An example using five year medical residency in a well-paying specialty in Ontario:
|Year||Salary||RRSP Room||Refund||Avg Marginal Rate (%)|
Strategy 1: Max the RRSP and claim the deduction annually.
If they maxed out their RRSP each year, then they would have contributed about 81K by the end of their second year as an attending. They would have received about 35K in refunds for an average refund rate of ~42.7% if they claimed the tax deduction each year.
Patience you must have.
Strategy 2: Delay claiming the deduction until their first year as an attending
Instead, they waited until their first year as an attending to claim their unused deduction (55K at that point) against their 240K income. Then, they would get a refund of about 28K. That is an average rate of 51% because the large deduction in a single year dropped then down a tax bracket for part of the refund. Much better, but still not optimal.
Strategy 3: Spread out claiming the RRSP deduction over two years.
They only claim a 20K deduction in their first year as a staff physician. That keeps the whole deduction in the 53.5% tax bracket. In the second year, their income is far into the top tax bracket. They can claim the 61K deduction without dropping tax brackets for the refund. They would receive a $43500 refund at an average refund rate of 53.5%.
The chances of being in a tax bracket below 53.5% (220K/yr income) in retirement when they draw the money is much better than being below 40% (~90K/yr income). So, strategy #3 has a better chance of the RRSP helping to not only defer, but to also reduce tax. Strategy #1 has a risk of increasing the overall tax bill.
Implications for Investment Planning
If you have limited money to invest during your training, you may want to prioritize maxing out your TFSA with growth investments instead of contributing to your RRSP.
Those starting out in practice also have other expenses. It may be better to pay down debt aggressive for the first couple of years instead of an RRSP. It is less attractive to tie money up in an RRSP when it would be best to delay claiming the RRSP deduction for a couple of years anyway.
For those who are debt-free and maxing their TFSAs. Start putting money in your RRSP. The sooner you take advantage of the tax-sheltered growth, the more the magic of compound returns will work for you. There are ways to strategically use an RRSP as part of an overall portfolio to minimize the potential tax pitfalls and leverage the tax deferral advantage.
So, who uses the simple top marginal tax bracket for their calculators the most?
Some lenders do as part of their RRSP loan calculators.
They ask you to enter your marginal tax rate. That vagueness causes many to simply put in their top marginal rate instead of their average rate. This is important because by making it look like you get a larger refund. Unsurprisingly, it makes the option of taking out a larger short-term RRSP loan look more attractive.
As we approach the end of RRSP contribution season, expect them to deploy their droid armies to try and sell these loans. In very specific circumstances they can be helpful, but you need to be aware of the potential pitfalls. We will cover that in another session at the Academy.