In Defense of the Registered Retirement Savings Plan (RRSP)

It is a known fact that many people do not like the RRSP and some even go as far as to say that they hate the things. Even accountants hate them – they always say that a dollar today is better than a dollar tomorrow yet when the question “how can I reduce my tax bill comes up” the default answer is often “contribute more to your RRSP”. A dollar today is often better than a dollar tomorrow but you also want to have a dollar tomorrow for retirement and everyone knows deep down that the Canada Pension Plan (CPP) and Old Age Security (OAS) will not necessarily provide you with a good retirement, if they exist when it is your turn to retire.

The RRSP does have its place in your tool box – it creates a deduction against your net income, a deduction not a credit. For people in a higher tax bracket this makes a difference – please refer to my previous post “Deductions and Credits: The Difference” for clarification if necessary. I will emphasize on what I believe to be the key point by using an example of an individual in the 30.5% tax bracket living in Alberta who has invested $1000.00 (The rate is 10% in Alberta and 20.5% Federal) versus the lowest rate in Alberta of 25% (10% Alberta, 15% Federal).

If you are in the 30.5% tax bracket the $1000.00 deduction will reduce your tax payable by $305.00

If you are in the 25.0% tax bracket the $1000.00 deduction will reduce your tax payable by $250.00

A $1000.00 non-refundable tax credit on the other had will reduce your tax payable by $250.00

That is why the RRSP really has no effect in the lowest tax bracket. Although it may be beneficial in two unique cases. Please note that these two programs are like a loan from yourself and that the tax bracket argument down below applies to this as well.

The home buyer’s Plan – You can borrow up to $35 000.00 from your RRSP to put down on a first home. You have two ways to pay it back, by contributing to the RRSP or by adding 1/15 of the amount withdrawn into income (You have 15 years to pay it back). If you are in the lowest bracket it isn’t a bad thing to take it into income.

The Lifelong Learning Plan – You can borrow up to $20 000.00 from your RRSP towards your education. You have the two same ways to pay it back as above – the only difference is you have 10 years to pay it back.

One neat thing that people may or may not know is that you can carry your RRSP contributions forward until you want to use them, some accountants I know of will apply them yearly regardless. As a result, if you run into that banker who says you should set up a pre-authorized checking (PAC) plan for $25.00 per month – you can accrue your yearly $300.00 RRSP contributions until you are in a higher tax bracket when they will save you a minimum of an extra $55.00 per thousand. Another important thing to consider about the RRSP is that you save from the first dollar earned (dollars before tax).

It is important to know that despite the fact that the RRSP does create a deduction against income, it is to be used as a tax deferral – they are NOT tax free. Some people I speak to say, why would I put into the RRSP – I am double taxed. When looking closer at the picture, you are not double taxed at all – remember the RRSP is a tax deferral – NOT tax free. You get the deduction and savings when you contribute to and apply the RRSP contribution to your tax return (You saved from the first dollar earned). It is correct that you pay tax when you go to withdraw because, in practice you were not taxed yet. One of the biggest problems I often see, is people will withdraw the RRSP when they are in a higher tax bracket or will withdraw and the income inclusion will put them into a higher tax bracket. If you withdraw the money at a higher tax bracket than when you contributed, it defeats the purpose. I’ll illustrate by using the example above.

If you are in the 30.5% tax bracket the $1000.00 deduction will reduce your tax payable by $305.00

If you are in the 25.0% tax bracket the $1000.00 deduction will reduce your tax payable by $250.00

If you contributed in the 30.5% bracket and withdraw in the 25.0% bracket, you will have saved tax at $55.00 per thousand. However, if you contributed at the 25.0% bracket and applied the deduction and withdraw in the 30.5% tax bracket, you will have paid $55.00 per thousand more in tax. Please note that this example holds true for both the Home Buyer’s Plan and the Lifelong Learning Plan.

The RRSP is not for everyone; it is a strategy that should not be used as a bank account, sometimes the Tax Free Savings Account (TFSA) may be better. I will explain the tax differences in an upcoming post titled “Would You Rather Pay Tax on the Harvest or the Seed?”. When looking at these strategies – it is always good to review your unique situation with an independent tax advisor or planner, sometimes it is good to get a second opinion as well because no one person knows everything.