The Hybrid RRSP Contribution Strategy: A Better Way to Build Your Retirement Nest Egg
Why Contribute to an RRSP in the First Place?
Contributions to an RRSP are a “tax-deferral” strategy. You aren’t going to eliminate paying income taxes, but you will defer paying tax on that money until many years down the road, typically in retirement. Sorry to bring up tax calculations in the article but the fact is that we have a progressive tax regime in Canada. We don’t have a flat tax system, the percentage of tax increases proportionally more at your income rises. This article is not meant to be a tax preparation course but the image below illustrates what a progressive tax system looks like. Simply put, as you earn higher amounts of income, the percentage of income tax paid goes up. The image below show 20% tax on the first $44,740 of taxable income but if you earned about twice as much (taxable income of $89,482 to $97,825), your percentage tax increases to about 34%. What that means is that for every additional dollar earned, you are paying 34 cents to the government. Thinking of it another way, you get back 34 cents on every dollar contributed to an RRSP for the higher tax bracket shown in this example.
So in retirement, if you expect your total income to be lower, say below a taxable income of $44,700, then you have not only 1) deferred the taxes all that time and 2) got a tax refund all those years but you will be in a lower tax bracket as well.
Do You Have RRSP Contribution Room?
Firstly, you need to have “earned income” during the year, which is income from employment, self employment and/or certain other types of income (read more here).You can then make a contribution of 18% of the earned income up to a specified income limit which changes each year. The RRSP limit for 2020 is $29,210 and if we divide that amount by 18%, we get a maximum earned income of about $162,277. Earned income above that is not used to calculate the RRSP contribution. (Please note: If you belong to a company pension plan, your contribution limit is lowered because company contributions affect the calculation which is beyond the scope of this article).
Do you have “Unused RRSP Contribution Room” from Prior Years
You don’t have to make an RRSP contribution or maximize your contribution each year, so this amount carries forward meaning it adds to your current limit. You can find that limit on your Income Tax Notice of Assessment (NOA) or read my article entitled “RRSP contribution limit” for more details.
Is it Better to Contribute to an RRSP or a TFSA?
TFSAs came into being in 2011 but they are very different than an RRSP. An RRSP gives a tax deduction for every dollar you contribute but when you take it out, you will pay tax then. Again, it’s referred to as a “tax deferral strategy”. On the other hand, the TFSA does not reduce taxable income but any income, dividend or capital gains are not taxed upon withdrawal. So if you have sufficient room to contribute or maximize both plans, great but if you can’t and need to decide which to do…read my article entitled “TFSA versus RRSP“.
A Hybrid RRSP Contribution Strategy
The Hybrid RRSP Contribution Strategy is explained below and I’ve put a simple spreadsheet for a sample client.
- Set up a monthly contribution to your RRSP and treat it like a bill. This is often referred to as “dollar cost averaging”.
- Then when you receive your Income Tax Notice of Assessment, you can adjust your monthly contribution according to the current RRSP contribution limit. Alternatively, you can wait until the first of the new year and do one “lump sum” deposit to top up your contribution to your RRSP limit before the deadline.
- If you have “unused RRSP contribution room” from prior years, consider taking that total amount and spreading the payments over the number of months until retirement For example, if you have $14,000 of unused RRSP contribution room and you’re 15 years away from retirement, it works out to $78 a month.
The Hybrid RRSP Contribution Strategy can be a more manageable long-term method to built and maximize your retirement nest egg.
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