You have probably been hit with relentless to contribute to RRSPs. “Don’t miss the deadline!”
This is usually also the time of year when accountants field many phone calls from clients asking whether buying RRSPs is a good idea and how much. Why are financial institutions pushing you to buy RRSPs now, and what’s this deadline all about?
Well, the banks and financial institutions know if you invest in RRSPs within the first sixty days of the new year, those contributions will help you reduce your taxable income when you file your tax return for 2021. They also know that after the sixty days, your RRSP contributions will not be applied against your previous year’s taxable income but against your 2022 taxable income. So, ‘tis the season to be barraged with RRSP ads.
Clients often ask me if it is worth it to buy RRSPs. My answer is that – from a tax perspective – it depends.
The idea of contributing to an RRSP is to lower your taxable income now when your income is relatively high compared to other times in your life. You will pay income tax on that money later when you withdraw it, but you’ll pay less in income tax than you would today. You effectively defer some of your income tax liability to a future date when you withdraw the money from your RRSP in retirement.
How do RRSPs work?
During your productive working years, most people will earn enough to be in a higher income tax bracket than they will when they retire. In other words, most people pay taxes at a higher rate while working. When you retire, your income decreases as you stop collecting a paycheck and begin collecting pensions and drawing on the investments you managed to put together over the years. The reduced income puts most people in a lower tax bracket. When you withdraw your RRSP investments, the money is taxed at the lower rate, thus providing you with long-term, overall, tax savings.
What if you are already in the lowest tax bracket?
In this case, it won’t make a difference to you if you purchase an RRSP or not. Sure, you could reduce this year’s taxable income and lower your tax liability, or increase your refund, by purchasing an RRSP. Still, all you are going to do is defer your tax liability to future years.
The actual amount of the liability will not change for you, and there will be no long-term tax savings.
One of the many questions that I get asked is. “How much should I contribute towards my RRSP, and how much will I save?”
Unfortunately, the answer isn’t always clear. There are a lot of factors to consider when trying to figure this out.
Talk to your accountant ahead of the March 1st deadline, and ask them to help you figure out whether you should and how much you should contribute. They will help you calculate your approximate taxable income. Once this is determined, they can test a few different contribution amounts using their tax software to see what the results look like. Armed with this information, you can then decide how much of a contribution you want to make and how you are going to come up with the money to purchase the RRSP.
Most of us wait until the last minute to buy an RRSP because we don’t think about taxes until it’s almost time to file. Then we scramble, looking under the sofa cushions or in the cookie jar to scrape together enough money for this year’s RRSP.
However, there are other ways. Consider setting up an automatic transfer of money from your bank account to purchase investments within your RRSP on a regular basis. You won’t miss the small amounts, and at the end of the year, your contribution will be taken care of without a scramble.
What about spousal RRSPs?
If you qualify, you can contribute to a spousal RRSP. You get to deduct the amount of the contribution made during the year on your tax return, but the income will be taxed on your spouse’s return when they withdraw the funds in the future. This is a very effective way to split future income if it is expected that one spouse will earn a higher income than the other after retirement. But be aware, if your spouse withdraws the funds from the RRSP within three years of contribution, that income becomes taxable to the contributor – you – once again, eliminating any potential future tax savings.
Using RRSPs to pay for the down payment on a home
Another topic related to RRSPs contributions that often comes up with clients at this time of year is how to handle the repayments to the Home Buyer’s Plan. The plan allows you to withdraw up to $35,000 from your RRSP investment to help you pay for your new home. Of course, you have to repay the amount back into your RRSP investment over a 15-year period to avoid being taxed. That means some of the money you contribute to RRSPs will be allocated as repayment of that borrowed amount and will not count as a new contribution for the tax year.
Remember, if you want advice on how to invest your money within your RRSPs, talk to your financial advisor. However, if you want to know the tax implications of your investments or how investing will impact your tax situation now and in the future – call your accountant.
As always, if you want to talk more about RRSPs or have any other tax questions, give me a call. I am more than happy to help!
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