We’re getting near the end of RRSP season, which ends on March 1st, but there’s still time make a contribution! With just a few days left let’s dig into what a Registered Retirement Savings Plan (RRSP) is, why it benefits you, and how to compare it against it’s younger counterpart, the Tax Free Savings Account (TFSA.)
This is a great time of year to think about your finances, but also give a few thoughts towards retirement. With the excitement of the holidays behind and the cold weather keeping you in doors this is a perfect time to do some financial housekeeping!
So What is an RRSP?
The name RRSP implies retirement, but it’s not restricted in a way that forces you to use it only for retirement, but it incentivizes you to use it that way. Incentives are a great way to think about any registered account, what positives are you receiving compared to the negatives you’ll face?
For an RRSP the major positives are that your money grows tax free inside of them. So you don’t pay any tax while the account grows. That’s a massive benefit, If we talk about a long term return on your investments of 6%, if you were paying taxes on that you could be losing anywhere from 1-3% of that to taxes. Which massively limits the compound growth you’ll see. You also get a deduction on your taxes when you contribute to your RRSP. In Nova Scotia that means you could be getting anywhere from 24 cents to 54 cents back for every dollar you contribute. The higher your income the more you’ll get back.
There’s Got to be a Catch?
Money back today from your contributions, and the money grows while it’s inside the account without owing taxes on it, those are both some solid incentives. Now, where is the negative? When you take money out of an RRSP it gets added back into your taxes as income. So you’ll be losing 24-54% of it when it comes out. So an RRSP is a way to defer your taxes. You get a refund when you contribute because future you will be paying when it comes out.
Your RRSP Isn’t Just About Retirement
Now there’s also a couple of ways for you to access funds in your RRSP without having to pay taxes, both require you to pay the money back over time, so think of them like an IOU to your RRSP. These are the Home Buyer’s Plan, and the Lifelong Learning Plan. The Home Buyer’s Plan allows you to withdraw from your RRSP to buy your first home, the Lifelong Learning Plan allows you to withdraw from your RRSP to fund education. Both plans aren’t for everyone, but if you’re in a position to take advantage of them, they can be incredibly useful.
But How Can You Make an RRSP Work for You?
The best way to look at an RRSP is to think of it as a tax vehicle. You’re trying to balance the benefits you get today, with the costs of it when you withdraw the money.
That’s easier to determine when you’re closer to retirement and have a good idea of what your income in retirement will look like. If you’re going to get more back from a contribution then you’ll pay when the money comes out in a few years, it’s probably a good idea. The way you can figure that out is to look at your marginal tax bracket (I tried not to use jargon, but this term is going to come up a bit, sorry reader!) this is a fancy way of saying the tax bracket your next dollar of income would be in. So if you make $50,000 per year your marginal tax bracket for 2023 would be 35.98%, so a dollar contributed to an RRSP would get you a 35.98 cent refund. If you expect your retirement income to be $35,000 then you know your marginal tax bracket will be 30.48% in retirement. This makes an RRSP contribution a pretty good deal, the funds you contribute get to grow tax free and you’ll have ‘made’ 5 and a half cents on every dollar that gets withdrawn.
If you’re going to be in a similar or higher tax bracket through retirement as you are in now, the benefits of an RRSP become less beneficial. In that case the TFSA becomes much more compelling.
I’m Not Retiring Tomorrow, What Should I do?
When you’re younger and retirement is much less tangible, it can be difficult to make a concrete choice between an RRSP and a TFSA. Typically, the higher your income the more incentive there is to use an RRSP, or if you’re planning to use one of the withdrawal plans I talked about earlier. What’s important to consider is how much flexibility you need, a TFSA allows you to withdraw funds without paying any taxes, that can be a much better place to contribute to if you’re planning a major expense or building out an emergency fund. If you’re working somewhere that offers RRSP matching, no matter what tax bracket you’re in, free money is always a good incentive, don’t leave it on the table!
RRSP vs TFSA
One of the biggest questions I hear when talking about RRSPs is whether someone should be using a TFSA instead. Especially now that they’ve been around a bit and people have gotten a bit of buyer’s remorse from their RRSP when it comes time to withdraw, and they owe taxes because of it. TFSAs are a powerful wealth building tool, but they are also far smaller contribution limits then RRSPs.
A TFSA doesn’t offer the tax deduction when you contribute, and doesn’t have any tax owing when you withdraw, so it’s much more flexible than an RRSP. That flexibility is valuable both before and after retirement. There’s going to be years where you spend a little more and not needing to worry about taxes is a huge advantage. However, don’t discount the value of ‘rolling your RRSPs’ which means contributing the tax refund you receive from your RRSP contributions, back into your RRSP, thus making a larger refund, and a larger overall contribution.
For most people a balance of both is likely what makes the most sense, because both serve different and useful purposes!
No matter what stage of life you’re in the best thing you can do for your financial future is to spend some time reviewing what you’re doing; any good plan needs to be reviewed and updated from time to time. If you haven’t started yet the best step, is the first one.
Laura Whiteland is a CERTIFIED FINANCIAL PLANNER® and Chartered Investment Manager® Professional, she is the owner of Inclusive Financial Planning, a fee-only financial planner. Laura also hosts Let’s Talk About It, a podcast dedicated to taking the stress out of personal finance.
This article is intended as general financial information and should not be construed as personalized financial advice.