When is the right time to invest in an RRSP?

When is the right time to invest in an RRSP?

RRSPs can certainly be a great tool for building your retirement nest egg and help you retire on time, but you need to analyze your personal situation first before making a decision. Based on your circumstances it could be wise to contribute, not contribute or withdraw funds.

Surprisingly, many people say that they don’t like investing in RRSPs, and that RRSPs are ineffective. This could certainly be true for some individuals in certain situations but as a wide-sweeping statement, it is certainly wide of the mark. When people ask what my thoughts on RRSPs are, I always say it depends entirely on the individual and their specific situation. Below I will go through the situations that four hypothetical taxpayers are in and explain why contributing to an RRSP may, or may not, make sense for each.

The main factors to take into account with all of the below scenarios are: how old the individual is, and at what stage of their career they are? Is there a probability that their income will be much higher, or lower, in a few years? When they plan on withdrawing the money from their RRSP, will they be in a higher tax bracket than when they contribute, lower tax bracket or the same?

The key rule of thumb with RRSPs is that you should contribute when in a high marginal tax rate, and withdraw when you are in a lower one.

Tom, age 24: Low-income earner in the early stages of his career, expects income to rise in the next 2 – 5 years.

In B.C., if you are earning $40,000 annually, your marginal tax rate would be 20.1%. If your income is $60,000 your marginal tax rate would be 28.2%. Tom is earning $40,000 now but thinks that in the next couple of years he will progress in his career and possibly earn around $60,000+. For Tom it would be best to wait to contribute to an RRSP until he is earning more as his tax deduction and return will be greater (8.1% greater in this case).  His RRSP room from 2020 will still be available in years to come, as since 1991 the federal government has allowed taxpayers to carry forward their unused RRSP room. For Tom, earning $40,000 today, contributing to a TFSA and utilizing this room ($6,000 in 2020) is the best way to earn returns tax-free. Broadly speaking, I suggest that people with a marginal tax rate of 25% or lower should use TFSAs instead of RRSPs.

 

Kate, age 31: Income will probably fall considerably in the coming years  

If you think for whatever reason that your income will fall considerably in the coming years (opposite to Tom in the first scenario) then contributing to an RRSP now, and withdrawing from it when your income is lower is definitely an effective strategy. In about three years Kate intends to start working part-time to be at home more with her kids, and she plans on doing so for four or five years. Kate should contribute to her RRSP now while her marginal tax rate is relatively high and withdraw when she starts working part-time. It is important to note that you can withdraw from your RRSP at any age (not just in retirement or under the home buyers plan). The key factor to always remember is that you want to contribute when at a high marginal tax bracket and withdraw when you are at a lower marginal tax rate.

Emma, age 54:  At the peak of her career regarding earnings

If you are a high-income earner and you believe that you are close to the peak of your earning potential then contributing to your RRSP will be quite advantageous. Emma, age 44, is a B.C. resident and earns $155,000 annually, which gives her a marginal tax rate of 45.8%. She believes that she will be earning this level of salary for the next 5 – 8 years and will then begin to reduce her workload and ultimately retire in her mid-sixties. Emma should fully utilize her RRSP room this year, and in the coming years while her salary is $155,000, by contributing the full amount ($27,230 for 2020). When Emma reduces her workload in later years her marginal tax rate will also reduce and therefore she will pay less tax on withdrawing from her RRSP.

 

Spousal RRSPs: One person earning significantly more than the other.

Spousal RRSPs are a great way of income splitting if one spouse or common-law partner is earning significantly more than the other. Take this example - one person makes $150,000 a year, and the other makes $50,000. Individual RRSP limits are 18% of your income from the prior year’s taxes, up to a maximum dollar amount that changes each year ($27,230 in 2020). If they both had RRSPs to which only the owner could contribute, the person earning $150,000 could put $27,230 into their RRSP (max amount for 2020) while the person earning $50,000 can contribute 18% of income, $9,000.

Although, when you have a Spousal RRSP, you can share contributions to your advantage. So the person earning $150,000 could contribute, say, $17,230 into their RRSP and $10,000 into their spouse’s/partner’s RRSP. They can still take the total $27,230 RRSP deduction on their income tax (and the other person will still contribute the $9,000 and take that deduction too). By evenly splitting your contributions in a Spousal RRSP, it will be easier to minimize your taxes when withdrawing in retirement. 

To summarize, contributing to an RRSP always makes sense if you have a higher marginal tax rate now than you will in the future when you withdraw the funds. This, of course, is not always simple and straightforward as we cannot perfectly predict what will happen in years to come, but hopefully, the above scenarios gave an insight into when putting money into an RRSP is best for you.

When contributing to your RRSP you will receive a tax refund, to really get ahead you can then contribute this refund to your TFSA to earn returns tax-free. If you are unsure about where to put your money after contributing to your RRSP, talk to your advisor about Wisdom Structured Investments or visit www.wisdomsi.ca. Wisdom offer principal-protected investments that track a leading Canadian equity index on double what you invest upfront, which will safeguard your retirement nest egg.

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