NITTY - GRITTY OF THE RRSP MODEL
Americans - think IRA or 401k when you see RRSP, and Roth when you see TFSA
- Deconstruct benefits showing the amount from each source. Compares outcomes between RRSP, TFSA and taxable accounts
- Conceptual model of how the RRSP works. As opposed to its mechanics.
- Decision worksheet for deciding whether $$ should added or removed from an RRSP. Additional variables are allowed for differences before and after retirement. RRIF drawdowns at the minimal required rate (instead of a lump-sum draw) is assumed.
Why you should read this page.
Below is a detailed argument, supported by math, proving that your probable understanding of 'how the RRSP system works' is wrong. It will prove that RRSPs have five effects that must be evaluated and calculated separately. No one before has bothered to calculate the actual benefits of an RRSP over investment in a taxable account, or developed the math for calculating the cost/benefit of each effect.
|1) ||The tax refund (contribution tax credit) is not a benefit to anyone. Taxes on earned (employment) income (NOT the growth within the plan) are deferred until the eventual withdrawals from the plan. There is no benefit from the deferral because it is a debt that grows at the same rate as the investments themselves. |
|2) ||Everyone benefits from the protection from tax on growth. This benefit equals the taxes on investment profits that would have been paid in a taxable account. It exactly equals the benefit of the TFSA. |
|3) ||One's marginal tax rate when withdrawing cash may be higher (or lower) than the rate at which one claimed the original contribution credit. This creates a penalty (or bonus) equal to the amount withdrawn multiplied by the change in rates. This is like a capital tax and nothing to do with portfolio profits. It will apply even if the portfolio has lost money. There is no generality that can be made beyond ... Those who contribute at the top marginal tax rate have a pretty good chance of taking money out at lower rates and receive a benefit. Those who contribute at the bottom tax bracket, have a chance of taking money out at higher rates and pay a penalty. |
|4) ||Canada has a variety of programs available to retired people whose benefits decrease as one's income increases. By deferring the income until retirement, the additional taxable income created by RRIF withdrawals at that time may reduce those benefits. It is a subjective decision whether to consider this disqualification for benefits 'caused' by the RRSP or by your good fortune. |
|5) ||Claiming the contribution tax credit may be deferred until a later year, but there is a penalty that grows with the length of the delay. The penalty equals the income the tax credit would have earned during the delay. (Its future value less the tax rate for the contribution). |
|1) ||Income earned inside the RRSP is taxed on withdrawal. |
|2) ||Dividends or capital gains earned inside an RRSP are fully taxed on withdrawal - without benefit of the dividend tax credit or the non-taxable half of capital gains. |
|3) ||The RRSP's benefit comes from the contribution tax credit that compounds tax free. |
|4) || The RRSP's benefit comes from the deferral of taxes. |
|5) || You optimize the RRSP's benefit by putting securities attracting the highest tax rate inside. |
|6) ||Most people's marginal tax rate in retirement will be lower than when they were working. |
|7) || You should delay claiming the contribution tax credit until your marginal tax rate is higher. |
|8) || Your RRSP account is too large when your expected tax rate on RRIF withdrawals is higher than the rate received for contributions. |
|9) || You should withdraw funds first from the RRSP (instead of taxable account) depending on the expected tax rate on future withdrawals. |
The RRSP's $benefit can be calculated as the difference between the outcomes using RRSP and taxable accounts. That total benefit can be broken down into its three sources - the tax free growth, the cost/benefit of a change in tax rates, and the cost of delayed claiming the contribution. The Challenge For All Detractors spreadsheet calculates the $benefit and shows its breakdown by source as argued here.
For all people wedded to a wrong understanding, you are challenged to develop your own math to explain the RRSP benefit in the way YOU think is correct. If you think you are correct, prove it. All the industry players have been challenged to disprove this spreadsheet and provide their own math. This list includes the big banks, the Investor Education Fund, the Get Smart About Money website, the Financial Consumer Agency of Canada, Investopedia, the Competition Bureau of Canada, the issuers of the CFP designation, the CAs, the Canadian Bankers Association. None have attempted the challenge. They simply stonewall.
There are also non-financial benefits/problems of an RRSP.
- The tax reductions on contribution and tax on withdrawals are powerful emotional carrots and sticks to encourage saving and prevent the raiding of those savings before retirement.
- RRSP assets are protected from the claims of creditors. The RRSP is a trust structure that is legally considered another 'person'.
- RRSP assets cannot be used as collateral for personal loans. For anyone wanting to use leverage investing this is a problem.
- RRSP assets may not be included in calculations of your wealth for qualification for some government benefits.
- The account may get preferential tax treatment if you move to another country.
Even the largest banks' education sites are WRONG, WRONG, WRONG. Witness this typical misunderstanding from the people trying to sell you advice.
Even the public accountants refuse to change their advice and continue the same old garbage.
Even the people appointed to judge YOUR financial knowlege get it wrong themselves.
Even the Consumer Affairs Department of the Government purposefully lie to you.
A simple proof.
Before continuing the more complicated model of 'how the RRSP works' here is a basic math proof of the assertions made at the top.
Forget all about tax accounts and just consider any portfolio. You are faced with the decision to either (A) pay the government 44% of the account's value now, or (B) pay the same 44% at some later date. Do you care which option is taken? No. As long as the tax rate does not change you will end up with the same $$. It makes no difference what period of time is considered or what rate of return is earned.
| ||Pay Now ||Pay Later |
| ||A ||B |
|Start ||1,000 ||1,000 |
|Pay Tax Now ||( 440 ) || - |
|Invested ||560 ||1000 |
|Growth over Time||8% for 35 years |
|Value Later ||8,280 ||14,785 |
|Pay Tax Later || - ||( 6,506 ) |
|End ||8,280 ||8,280 |
You will recognize -
(A) represents the TFSA. Earned Income is taxed when earned, so only $560 would have been invested. The $560 grows at 8% without any taxes being deducted.
(B) represents the RRSP. The $1,000 Earned Income is invested without any income taxes being deducted. It grows at the same tax-free rate as the TFSA. The taxes paid by the RRSP on withdrawal are not taxes on the portfolio's profits. They are the Future Value of the unpaid tax on the original employment income (PV=$440 n=35 i=8%).
In both cases the original $1,000 Earned Income is taxed - either when earned or later at its Future Value. In both cases the investment income is NEVER taxed. There is no benefit from not-paying taxes at the start, because it was just deferred. There is no benefit from the deferral of tax because the liability grows at the same rate as the investments. The added complication of any change in tax rates will be addressed in the more complicated model following.
What are the mechanics of the RRSP system ?
Most Canadian know the mechanics of the RRSP system. This webpage does not dispute them.
- Contributions to the plan create a tax deduction. The resulting reduction in tax is commonly called the contribution tax credit. Your marginal tax rate on contribution is a variable in the model. An arbitrary $1,000 contribution is used.
- Inside the plan, the contribution is invested and grows tax-free. The rate of growth is a variable.
- The government hopes the plan is left intact until drawn down gradually in retirement. That reality is too difficult to model, but there is an easier understanding. Consider that contributions are made each year of a working life - 35 years from age 30 to 65. Each year's contribution grows over a 35 year period and then funds one year's retirement income - 35 years from age 65 to 100. The model shows a default term of 35 years, but it is a variable because the fund can be collapsed at any time.
- When withdrawn, tax is levied on the total draw. Your estimated tax rate is a variable.
Some people are stuck in the 'mechanics' of the RRSP and believe the mechanics prove the 'benefits'. They are likely to state "Income earned inside the RRSP is only tax-deferred, not tax-free, because the total balance of the account is taxed on withdrawal.". This POV is wrong because it isolates only one part of the RRSP system and ignores the other parts.
The money you save must do a full round-trip into and out of the RRSP before you can use it. The mechanics of both the contribution and withdrawal come into play. The individual steps don't prove the net result. You cannot pick just one step and conclude it proves a benefit (or cost). It is the net benefit that counts.
The model developed below is interactive on The Model spreadsheet. Open it now and play with the variables as they are added below. This is a conceptual model of what is happening inside an RRSP, to show where and how its benefits are generated - what is going on and why. Models should always be structured to simplify as many factors as possible, even while reflecting reality. It does not try to be a worksheet for personal decisions.
So, to start. In The Model cash that creates an RRSP contribution is considered to be a combination of after-tax savings plus the tax credit. It makes no difference to the conceptual model if, in reality, you spend your refund, invest it elsewhere, or never receive it. Your contribution creates the tax effect, regardless.
People dismiss the Model because they think it does not reflect what they personally do with their cash flows. A common argument is: "I don't put the contribution tax credit back into the RRSP. I do ... something else ... with it. So The Model is wrong."
- The first point to clarify is that the division within The Model between the two columns is conceptual. The cash for contributions comes from your chequing account, not from specific sources like a tax refund or a pay cheque.
- Don't get hung up on refunds. Lots of people don't get any.
* Consider the person with a taxable portfolio of investments. The RRSP refund calculated on his tax return gets wiped out by the taxes owing on investment profits. Similarly when there is additional income from renting out your basement suite, or from a small business.
* Consider the person who told his employer to lower his pay cheques' tax withholdings, and contributed before-tax savings.
* Good tax planning aims to prevent any tax refund. A refund only indicates that you gave the government too much money too soon. If you delay recovery of the RRSP benefit that is your personal decision, not an attribute of the RRSP system itself.
- Don't get hung up on refunds. Lots of people cannot use them for any kind of additional savings.
* Consider the person who relies on the RRSP refund to pay his yearly property taxes. Without the refund he would have had to save extra $$ in a taxable account, and would not have been able to make as large an RRSP contribution.
* Consider the person who borrows to top-up his contribution and must use the refund to pay back the debt.
* Consider the person who temporarily draws-down the balance of his emergency fund to top-up his contribution, and must use the refund to replenish it.
* What you do with any refund you do receive is irrelevant to the RRSP system itself.
- The source of savings makes no difference to how the RRSP works. It makes no difference whether the cash comes from a government cheque or a payroll cheque. The account is just a pot of dollars. Your RRSP won't work differently from JoeBlow's just because you funded them differently. The reality of the person who contributes $5,000 savings from pay cheques and uses his refund for a vacation, is no different from the reality of the person who first contributes only $4,000 from his pay cheques because he went on vacation - and then contributes his $1,000 tax refund as well.
Similarly, the person who creates a taxable investment account with the refund is simply making the decision to NOT use the RRSP. The fact that its funding came from an RRSP refund makes no difference. You are simply allocating your savings to a taxable account. The benefits of RRSPs accrue only for the $$ inside them.
- The timing of cash flows within a year makes no difference to an understanding of the RRSP. For simplicity they are all lumped together. It makes no difference to decisions you make between possible choices. Yes, the person who contributes in January will realize greater benefits from an RRSP than the person who waits till the last minute each year, but it won't change any decision/choice.
- Don't get hung up on the calendar date of events. For people who put the tax refund of one calendar year directly into an RRSP contribution dated the next calendar year, it is simpler to consider 'a year' to be a fiscal year that runs from (say) June to May. That way you can understand the refund to be integral to the original contribution.
- The math for the tax refund becomes an endless loop when you
a) make a contribution,
b) calculate the refund equal to the contribution * your tax rate,
c) contribute the refund,
d) calculate the refund equal to the second contribution * your tax rate,
e) contribute the refund, etc.
Much simpler to consider the refund to be integral in each contribution, no matter when or how or if it is received.
- If you insist for your personal reality, that recovery of the refund and its contribution is delayed a year, then use the model's variable for a delay in claiming the tax credit (discussed below). It won't be a perfect model of your reality, because the delayed contribution creates its own refund, but it is close-enough. But the delay is your choice and not an attribute of the system. Obviously the sooner you get the tax benefit the better, even if it is not used for a further RRSP contribution.
The Model tracks what happens to the two parts of the total contribution separately. The left column tracks the same after-tax savings that might have funded a TFSA contribution. This savings grows at the rate of return you use as a variable. It grows tax-free just like the TFSA would. Its Future Value will be exactly the same as the value of a TFSA.
What does the tax on withdrawal do ?
Now we have a model that shows what goes into an RRSP contribution and how each portion grows over time. We know the total $$ withdrawal tax, but how it is allocated between the two columns?
The RRSP system presumes that your tax rate at contribution is the same as your rate at withdrawal. This presumption is relaxed below, but for now just accept it. When the tax rates do not change, the tax on withdrawal will equal the future value of the tax credit. The contibution tax credit was never a benefit - it was a loan from the government. The withdrawal tax is not an 'income' tax. It is the paying back of a loan, along with all the income it earned.
When you allocate all the withdrawal tax against the future value of the original credit, it zeros-out that column and leaves the after-tax savings portion in the left column untouched. This is exactly what the objective of the RRSP was - it's major purpose. The income earned by your after-tax savings is not taxed - not within the plan and not when withdrawn. Even the income on the government's loan is never taxed, but you don't benefit from that.
If the analogy of 'a loan' is not clear, here is another analogy. Consider that your best friend Bob gave you $440 of his own money to invest for him, alongside your own $560. His money would then have funded 44% of the account. Over time, 44% of the account remains 'his', not 'yours'. When you close the account he gets his 44% back - regardless of the profits/losses earned in the mean time. His $6,506 portion is an allocation of principal, not a tax on profits.
This concept of 'ownership' by the government (of a portion of your account) plays out in the Asset Allocation process. You don't AA the full value of the account. You only AA the portion owned by you. See discussion on the RRSP Decisions page
The 'experts' commonly say "While the income earned within the RRSP is not taxed - it IS taxed on withdrawal. This is wrong. Don't confuse the mechanics of the system with what its effects are. The left column is no different from the TFSA (where everyone agrees there is no tax on earnings - ever). So now you understand the biggest benefit of the RRSP - no taxes on income earned.
RRSP's deferred taxes are not a benefit.
It is common to hear: "The RRSP's benefit is from deferring tax. A dollar today is worth more than a dollar tomorrow, so there is a benefit from the delay". But there is no benefit from deferring payment of a liability unless the income you can earn in the interim is greater than any increase in the liability. There is no benefit from the deferral when your $100 bill can be paid today or
This is the same situation in the RRSP. Your liability for the tax on employment income you didn't pay at the start, grows at the same rate as your investment returns. You end up no better off from the deferral. This shows in the middle column of the model. The taxes paid on withdrawal equal the all the original credit plus all the income it earned.
- invested at 10% but your bill becomes $110 at the end of the year, or
- invested at 20% but your bill becomes $120 at the end of the year, or
- invested to lose 5% but your bill becomes $95 at the end of the year.
The deferral of tax can cause two problems, both of which are discussed fully further below.
So, while the deferral of taxes is of no benefit, it does have possible downsides.
- The tax bracket you end up in when the taxes are eventually paid may be higher (or lower) than the rate of tax at which you originally received the credit on contribution.
- In retirement you are eligible for government benefits that may be clawed back when your income exceeds certain levels. The deferral of tax until that time may result in a reduced benefits.
The contribution tax credit has no value.
People mistakenly consider the contribution tax credit a value in itself. You are told it is - that getting it is a reason for contributing. You are told that you will have more money earning higher $profits as a result. You take the balance of their RRSP account at its face value and think that is your net worth. By now you should know that the contribution tax credit is an ephemeral value. It has no value for the taxpayer. It is a loan, not a gift.
The illusion of this 'value fluffing' of the apparent size of an RRSP can be a problem, especially for people contributing at the top tax rate. For them, almost half the portfolio's value is due to the ephemeral credit. When periodically calculating your net worth, you should subtract a rough estimate of the taxes you must pay on withdrawal. Exactitude is not necessary.
The fluffed-up value in the RRSP leads to errors in asset allocation when assets are held in both RRSPs and taxable accounts or TFSAs. The RRSP asset should not be 'measured' at it's account value when comparing it to an asset's value in a taxable account. The estimated withdrawal tax should be deducted. See the discussion on the RRSP Decisions page.
The illusion of this 'value fluffing' causes people to think they can game the system. They contribute free cash into an RRSP, then use the tax credit to fund a TFSA. They wrongly think they have magically grown their savings.
The claim that the contribution tax credit is a value leads to various wrong financial decisions;
- when choosing between long term TFSA or RRSP funding,
- when choosing between saving for a real-estate purchase in an RRSP, TFSA or outside both.
- when choosing between paying down a mortgage or contributing to an RRSP.
- when deciding to borrow the cash for a contribution.
- when comparing the value of tax reductions for charitable donations and tax reductions for RRSP contributions.
- when arguing the merits of government's social policy regarding pension taxation.
What tax rates do you use in the analysis ?
The tax rate used as a variable in The Model spreadsheet for the CONTRIBUTIONS and DRAWS is not the marginal rate of the next dollar of income. Rather, it is the rate applied to the total RRSP contribution or withdrawal. First calculate your tax bill without any contribution or withdrawal. Then calculate it again with the contribution/draw. Subtract for the difference. Divide the $tax difference into the $contribution/withdrawal to get the marginal tax %rate.
The model represents each year's contribution growing over time to support a year's withdrawal in retirement.
When using the In Or Out spreadsheet for practical RRSP decisions whether to contribute, the TAX RATE ON WITHDRAWAL should be the incremental tax rate on withdrawal resulting from only the additional amount being considered for contribution. For example, a young person in the bottom tax bracket would expect to also withdraw those savings in retirement also in the bottom tax bracket, assuming CPP benefits use up the 0% tax bracket. But after 10 years of contributions and great rates of return, the account will have grown in size, The Minimum Required Withdrawals of the existing account are now expected to use up all the bottom tax bracket. Any additional contributions will be incrementally taxed at the second tax bracket on withdrawal. It is the second tax bracket's rate that should now be used for the decision to make an additional contribution.
RRSP withdrawals qualify a 'pension income' that can be split between couples in whatever proportion they choose. This may lower the effective withdrawal rate when one spouse has unused tax brackets.
The In Or Out spreadsheet includes a variable for the TAX RATE ON INVESTMENT INCOME if it had been invested outside the RRSP. While you are working, investment income earned outside an RRSP will be taxed at increasingly high marginal rates. Your salary will rise (hopefully) and also the amount of your taxable portfolio. By the time you retire both can be very high. There is no one correct variable input because it will be changing. See the effects of different inputs. After retirement, depending on the size of your CPP and other pensions, your tax rate can be very low.
At retirement, some people conveniently forget all the past tax protection (on investment income) and start belly-aching about the high taxes they pay on RRSP withdrawals. They compare withdrawal taxes to the low taxes they would pay if the investments were outside the RRSP. This is especially prevalent among richer people already covered by pension plans, who would not need more income in retirement, but used the RRSP anyway to shelter investment income while working.
This is disingenuous. They knew full well they were moving taxes to their retirement years. The problem of facing a higher tax bracket in retirement has been widely discussed since at least 1985. Their high minimum withdrawals are probably the result of wonderful stock market returns they did not anticipate. They should count their lucky stars.
What happens when tax rates change ?
Inside an RRSP you get a bonus when your tax rate on withdrawal is lower than it was for the contribution. You pay a penalty when your tax rate rises. The amount of the bonus/penalty
= the amount withdrawn multiplied by the change in rates.
The difference in tax rates can be influenced at either end. You try to time your contributions to be at a higher rate, and you try to time your withdrawals to be at a lower rate. But be clear that just because you try to maximize the contribution tax credit does not mean it is a benefit in itself. It is the difference in rates that generates the benefit/penalty.
Play with the variable inputs for the 'Tax Rates'. You will see that a same 10% difference in rates has a greater RELATIVE impact on people at the higher tax brackets. This is because it is calculated on the fund total. For high tax bracket earners, more of that total plan value was created by the government's loan. This makes contributing into a spousal plan (where the spouse will be withdrawing at a lower tax rate) even more important for high wage earners. Same with pension income-splitting.
This effect (of a change in tax rates) is the major difference between the TFSA and the RRSP. Rate changes have no effect on a TFSA. In the example above, the value of the TFSA would be $8,280 regardless. It is most meaningful to calculate the penalty/bonus in relation to the amount that should have been available - the amount that would have been available in an TFSA - the $8,280. The formula is
( Change in tax rate % ) divided by ( 1 minus tax rate on contribution )
10 / ( 1 - 0.44 ) = 17.9 %
17.9 % * $ 8,280 = $ 1,479 bonus
This calculation shows how regressive the RRSP model is. Compare that 17.9% bonus from a 10% reduction at a high tax rate --- to the bonus from the same 10% reduction at a low tax rate. Change the contribution and withdrawal rates to 30% and 20%. The lower income persons gains only 14.3% above what they should have received.
( Change in tax rate % ) divided by ( 1 minus tax rate on contribution )
10 / ( 1 - 0.30 ) = 14.3 %
14.3 % * $ 10,350 = $ 1,479 tax.
The government could have got rid of this problem simply by stipulating all contributions(draws) be taxed at the first tax bracket's rate. Even during the pension reform discussions after the 2008 credit crunch there was NO discussion regarding this regressive tax or calls for change. It is likely that policy was written specifically to benefit the high income earners while hoping the poorer classes never find out.
What are the unknowns that will determine a tax rate change ?
The effect (positive and negative) of a change in tax rates is an unknown until the time of withdrawal. It is a risk. Anyone telling you that it is a certain benefit is a snake-oil salesman. The only people in a position to 'assume' a bonus are those contributing at the top marginal rate.
One way to deal with the unknown withdrawal tax rate is to make it the 'conclusion' instead of the 'given' in your analysis. Use the In or Out spreadsheet to find the break-even point in your particular decision. Make your best guess for all the other variables, then play with the withdrawal tax rate variable until both choices are of equal value. Then ask yourself "what is the probability of the future tax rate being larger/smaller than that variable?"
Some people say you should never assume your tax rate will rise on withdrawals because you could always withdraw the funds first, before your rates rise. There are two problems with this. First, most of the unknowns listed below will be unknown until they happen - too late. Second, withdrawing funds early would be shooting yourself in the foot - giving up the shelter from tax for your savings.
Other people claim you should never assume your tax rate will rise because you should stop working and amassing wealth before that happens. Do you really need to told how silly that argument is? Some people will spend $100 to save $1 in taxes.
The only certainty is your tax rate on contribution. Following is a list of variables that will impact your tax rate on withdrawal.
- Your total income when withdrawing
- If you die the year you retire, the total RRSP balance gets taken into income in one year. That can push a lot of it into the top marginal tax bracket. The extend of this risk depends on the amount in the plan.
- If you withdraw larger amounts than the minimum required, they may push you into a higher tax bracket. E.g. if you need money to pay for long-term care, or take an around-the-world cruise.
- The amount you save inside the RRSP and the investment returns you earn.
- The bigger the fund at retirement the larger the required draws. Even if you worked and contributed in the bottom tax bracket, it is possible to create a fund large enough so that the draws push you into the next higher tax bracket, or even beyond.
- Your savings and investing results outside the RRSP impact the income you must consider BEFORE calculating the marginal tax bracket of the RRSP draws.
- Maybe you inherit a large sum.
- Maybe you realize a large gain from the sale of your principle residence that gets invested and earns income.
- Maybe you keep savings outside the RRSP because of the high cost of foreign exchange conversions.
- Government programs
- Any income you receive from Canada Pension Plan, Old Age Security, etc, should be considered as taxed first at the lower rates. The greater the government benefits, the farther along the tax-bracket scale the RRSP draw is pushed.
- Government programs providing income assistance in retirement (GIS, OAS) have clawback provisions that reduce the benefits when your income exceeds certain limits. This has the effect of increasing the effective marginal tax on any RRSP withdrawals. This effect does not exist for TFSA's.
- Tax rates can be changed by the government at any time.
- The deficit spending by governments in 2009 may force increases to future tax rates. Someone will have to pay.
- The economy in general and government deficits will determine political realities.
- The retired persons lobby groups may influence rate decisions.
- The width of tax brackets (how much income is taxed at each level before you get bumped up to the next tax rate) may increase with inflation, or not.
There are only two relatively safe assumptions that can be made from all these unknowns.
- Those who contribute at the top marginal tax rate have a pretty good chance of taking money out at lower rates. Therefore they benefit from the rate change.
- Those who contribute at the bottom tax bracket have a chance of taking money out at higher rates, if they are good savers and investors. Therefore they lose from the rate change. This reality is what prompted the government to create the TFSA.
Many government support programs are means-tested. Their level of benefit depends on your income. The reduced income from an RRSP contribution may increase the Child Tax Credit or the GST Credit. The increased income from an RRSP withdrawal may reduce Old Age Security, the Guaranteed Income Supplement or the Age Tax Credit. How you deal with these for tax planning depends on how entitled you feel to the benefits.
For example, a huge fuss is made about the clawback of Old Age Security benefits. People need a reality check. The mean income in Canada is about $40,000. Anyone earning more than $60,000+ (at which OAS only starts to be clawed back) is far above 'normal' and certainly not deserving of taxpayer support, especially when the taxpayers are earning less than the people they are supporting. Consider how you feel about people who refuse to get a job because the paycheque earned will be offset by a reduction in welfare benefits. Do you think these people are doing 'good financial planning'? Or do you think they are abusing the system? Do you see the analogy?
Do you feel blessed to not qualify for benefits because you are wealthy? If so, just ignore this issue.
If you see this as a 'tax' then treat the $$ benefits lost/gained as an increase/decrease in the $$ taxes paid. In both cases you calculate your marginal tax rate as the difference between the $$ taxes paid (with or without the RRSP transfer), divided by the $$ of the RRSP transfer. The $$ benefits gained on contribution will further reduce $$ taxes , and increase the marginal % tax rate on contribution. The $$ benefits lost on withdrawal will increase $$ taxes more and increase the marginal % tax rate on withdrawal.
Delay Claiming Contribution Tax Credit ?
The RRSP administrative rules do not force you to claim the contribution tax credit in the same year you contribute. Since the credit is calculated at your top marginal rate, it seems intuitive that it is better to delay the claim when you predict your future marginal rate will rise. After all, a $440 refund (44% tax credit on $1,000 contribution) is better than a $340 refund (at 34%).
Use The Model spreadsheet as it stands so far (above). The variables show in the table below, except for the Delay (yrs). Leave the Delay variable blank. You see that the lower tax rate on withdrawal ( 34% instead of 44%) created a bonus $1,479. What happens when you delay claiming the tax credit? The delay creates a penalty that grows with the length of the delay.
Watch what happens to the numbers when you input a delay of 5.5 years. The middle column shows the tax credit being invested for only 29.5 years - not the full 35 years. As a result it grows to a smaller total ($4,260) instead of the $6,506 when there was no delay. The penalty for the delay equal this difference multiplied by (1 minus the tax rate on contributions). In this case ( 6,506 - 4,260 ) * ( 1 - 0.44 ) = $1,257.
The RRSP's ending value is now $3 less than what you would have earned inside an TFSA. The deconstruction of benefits in the lower box of the spreadsheet, shows that the penalty from the delay ($1,257) is slightly larger than the bonus from the difference in tax rates ($1,254). So in this example you are better off delaying the claim NO LONGER than 5.5 years
You must weigh the benefit from contributing at a higher tax bracket against the penalty created by a delay claiming the credit. Are you very, very sure your income will rise? How fast will the penalty wipe out the bonus from a higher tax rate? It might be better, if you have room in a TFSA, to stash the $$ there until your tax rate rises and you contribute (and claim) to an RRSP later.
RRSP Decisions and Choices
After the list of decisions grew too long, it was given a page of its own at RRSP Decisions.