Like Yoda, RRSPs may be seem old, but they are actually very powerful.
This post is not intended for those completely untrained in the ways of The Force. If you know very little about RRSPs or TFSAs or [gasp] “don’t get the attraction of Star Wars”, then you have those two features in common with my wife. You should go back and read about the basic anatomy of RRSPs and TFSAs. That will help you with your first problem – I am not sure what to do about your second more serious issue.
For the rest of us, Master Yoda will spend some time with us today helping to hone our RRSP Jedi Mind Tricks.
For those who don’t know [sigh] what Jedi mind tricks are, they are when a Jedi uses the power of his mind to command someone with a weaker mind, like a Stormtrooper or your in-laws. You can get some quick tips in this demo from Obi Wan Kenobi. We can also bend the power of RRSPs to better do our bidding. However, like anytime we use The Force, there is potential for good, but we must also be careful not to embark on a path to the Dark Side.
I was going to put all of the RRSP Jedi mind tricks into one post, but it was more than my human mind could take. So, we will focus on only one mind trick per post. I have also made an RRSP Jedi Mind Tricks Calculator as an ectopic mind for you to use to see the numbers in action and for you to be able to tailor them to your own situation.
Welcome young Jedi, clear your mind, feel The Force flow in everything around you.
RRSP Jedi Mind Trick #1 You don’t have enough money to contribute to both your RRSP and your TFSA. No problem. Let Master Yoda show you how to supercharge your retirement saving with your RRSP.
Let’s say you have a salary of $145K and make the max contribution of $26010/yr to your RRSP.
This results in a tax refund of ~$11.5K in Ontario.
- You invest $5500/yr of that in your TFSA and the left over ~$6K in a non-registered account with your overall diversified portfolio returning an average of 8%/yr (6% after inflation).
- After 25 years you would have a retirement income of about $87K/yr.
- But wait, even better, $17K of that is tax-free income from your TFSA which means a total after-tax income of 74K/yr!
When you were working, you were living on a gross income of about $119K or net income of $86K after tax. Your retirement income after tax would be about $74K. You could retire after 25 years of work with no change in your lifestyle. In fact, it would likely be better without the expenses required to work.
If you give in to the allure of the Dark Side and spend that $11.5K tax return each year instead of using it to supercharge your TFSA and other investments, then you would need to work another 8 years to be able to retire with same $74K/yr net income.
Is living on $86K instead of $98K now worth working eight years (33%) longer? Only you can answer that question really. I just want to make you sure you know the possibilities.
Many professionals will make much more income than in this example.
This sort of delayed gratification becomes much less of a sacrifice as you make more money since you have more discretionary spending money. Increasing your spending past a certain threshold brings diminishing returns on happiness and time.
From a strictly financial standpoint, using an RRSP actually disproportionately benefits those who earn more income since they have the highest marginal tax rate currently. For example, if your income is $246K/yr instead of $145K, your refund would be 14K/yr and you would have an after-tax retirement income of 78K/yr after 25yrs. You contributed the same amount to your RRSP, so that incremental increase in your retirement income is a supplement from the government. While saving for retirement, you would be living on an after tax income of $150K/yr or you could live on less and accelerate your retirement saving in your non-registered account even more to either retire earlier or have an even higher retirement income.
Many high income professionals have a Canadian Controlled Private Corporation and pay themselves via dividends.
You need to pay yourself a salary to be able to make RRSP contributions and take advantage of this Jedi mind trick. So, the question arises. Is the cost of making CPP contributions and decreasing the retained earnings in your CCPC from paying yourself some salary offset the benefits of paying yourself a salary and contributing to an RRSP. This question has several dimensions which are in flux with the impending tax changes to CCPCs that the government is moving on. I suspect it will tip the balance towards salary/RRPS. When we have the new rules of engagement, we’ll have to have a UFC match between CCPC salary versus dividends.
On the other end, if you only make enough to contribute to either your RRSP or TFSA, then the best strategy depends on why that is.
If make enough money that you are in a high marginal tax bracket, but don’t have enough to contribute to both your TFSA and RRSP. Well, you need examine your spending now, how much you plan to spend in retirement, and what you need to save to have enough to retire when you plan to. It is better to look at this now to make sure that you are on track rather than find out later when it is too late. You cannot make up for the lost time of investment compound growth. You are also not likely to be physically and mentally more able to work harder when approaching the age that you are starting to eye retirement than you are now. Visit the Battleschool Simulator if you don’t know what I am talking about.
If you are in a low marginal tax bracket, you do not get much of a tax refund. You are also less likely to be in a significantly lower marginal tax bracket when you retire than you are now. Don’t tell the Supreme Chancellor or his sith apprentice, but RRSPs are really of benefit to those who earn high incomes. Ironically, the first thing they did, when elected to the Galactic Senate, was decrease the TFSA contribution limits. Their spin was that only rich people could afford to save money in them. Remember, that an RRSP is really only tax deferral – hopefully from a high marginal rate to a low one. With an RRSP, the T2 will be back for your taxes. You will also likely qualify for various forms of government low income supplements when you are old and decrepit that income from a TFSA does not reduce or negate. These factors mean you are likely better off maxing out your TFSA first.
Many Canadians will fall into a more upper middle class tax bracket. If you have an income in the $90000-100000 range, you could put around 15k into your RRSP, get a refund of around $5500 to then top up your TFSA. You have turned 15K of your money into 20K of tax-advantaged investing using this RRSP trick. Yes, you will have to pay tax on the 15K some day, but hopefully that is at a lower tax rate and in the interim it makes tax free gains. Plus you start growing your TFSA room to spit out tax free income down the road!
What if you are in a high enough tax bracket that you benefit from RRSPs, you have been a good padawan and have enough to almost max out your RRSP and TFSA, but fall just a little short?
- “Short? Short?!?!? Judge me by my size do you? “
- “Much to learn you have.”
- “Teach you more a future post I will.”