Are RRSPs Really Worth It?

Are RRSPs really worth it, or could your retirement savings eventually create a major tax burden?

That question has become increasingly common among Canadians. Search for information about RRSPs online and you will find plenty of warnings claiming that an RRSP is a tax trap. Critics point to taxable withdrawals, forced retirement income after age 71, potential Old Age Security clawbacks and the possibility of a large tax bill when an RRSP passes to an estate.

Those concerns are not entirely wrong.

If you invest in RRSPs without understanding how the deduction, refund and withdrawal rules work, your registered retirement savings could create an expensive tax problem later. However, when an RRSP is used strategically, it can also be one of the most powerful tax-deferral tools available to help Canadians save for retirement.

The important question is not simply, “Are RRSPs worth it?”

The better questions are:

• What is your current marginal tax rate?

• Will you have a lower tax rate in retirement?

• Will you need to withdraw the money early?

• Will you reinvest your tax refund?

• Do you have a plan for your retirement income after age 71?

• Could a large RRSP push you into a higher tax bracket?

• Are you investing in an RRSP at the right stage of your career?

In his latest video, Devin Rice, a financial planner at Rankin-Rice Wealth Management, explains how RRSPs work, where the tax advantages come from and how to avoid turning your retirement savings plan into a future tax burden.

Future RRSP Contribution Limits and Contribution Room

Your available contribution room tells you how much you may be able to contribute to an RRSP, but having RRSP room does not automatically mean you should use all of it immediately.

Many young Canadians are told to maximize their RRSP as soon as they begin working. However, this may be a mistake for someone who is currently earning less than $60,000 and expects to earn a higher income later in their career.

Someone in a lower tax bracket may receive a relatively small refund from an RRSP deduction today. If that person expects to move into a higher tax bracket later, the deduction could potentially be more valuable during a future tax year.

Before you make an RRSP contribution, consider:

• Your current income

• Your current marginal tax rate

• Whether your income is likely to increase

• Whether you may need the money in the near future

• Whether you will reinvest the tax refund

• The tax rate you may pay when the money is withdrawn

• Your expected income in retirement

Your RRSP contribution room is only one part of the calculation. The potential tax savings depend heavily on when the contribution is deducted and when the money is eventually withdrawn from your RRSP.

Should You Maximize Your RRSP Contribution Room?

Maximizing your RRSP may be more effective when you are receiving a deduction at a higher tax rate than the rate you expect to pay during retirement. It may be less effective when you receive the deduction in a lower tax bracket and later make RRSP withdrawals while paying a much higher rate.

The worst-case scenario is receiving an RRSP deduction at approximately 30% and withdrawing the money later at approximately 50%.

In that situation, the tax deferral may work against your overall wealth-building strategy.

Before using all your available contribution room, consider whether you are currently in the best tax year to claim the deduction.

What Happens to RRSP Contribution Room After a Withdrawal?

One of the biggest differences between an RRSP and a TFSA is what happens after a withdrawal.

Once money is withdrawn from your RRSP, that RRSP contribution room is permanently lost. You cannot simply put the withdrawn amount back during the following year.

This is different from the flexibility associated with a tax-free savings account.

Contribution room used for money later withdrawn from an RRSP does not return. That is why an RRSP should not be treated like an emergency fund or a regular savings account.

You Can Carry Forward RRSP Contributions and Tax Deductions

You have the ability to make an RRSP contribution now and defer claiming the related deduction until a future year. This can be particularly useful for someone early in their career.

You may contribute to your RRSP, allow the money in the RRSP to begin compounding and wait to claim the RRSP deduction until a year when your income is higher.

For example, someone earning less than $60,000 may expect their career and income to grow. Instead of using the deduction while they are in a lower tax bracket, they may choose to save it for a year when their income has increased.

The money can remain within an RRSP and continue compounding while the deduction is deferred.

This strategy allows the investor to separate two decisions:

1. When to make an RRSP contribution

2. When to claim the tax deduction

Why the Year When Your Income Increases Matters

The year when your income rises may be a more valuable time to use an RRSP deduction.

If you claim the deduction while earning a higher income, the resulting tax refund could be larger than the refund you would receive while earning less.

The potential advantage depends on the difference between:

• The marginal tax rate when you claim the deduction

• The tax rate applied when you withdraw the money

RRSPs work most effectively in the example provided when the investor claims the deduction at a higher tax rate and withdraws the money later at a lower tax rate.

This is why the decision to contribute to an RRSP should be connected to your broader income and tax strategy.

Carry Forward the Deduction, Not the Withdrawal Room

It is important not to confuse carrying forward a deduction with withdrawing money and replacing it later.

You can leave the money invested within an RRSP while delaying the deduction.

Once money has been withdrawn from your RRSP, the contribution room is lost. 

Tax Deductions for RRSP Contributions

One of the primary tax advantages of an RRSP is the deduction associated with your contribution. An RRSP is a tax-deferral tool. You receive the benefit of investing pre-tax money today, allow the full amount to compound and pay tax when the money is withdrawn later.

This means an RRSP deduction can create an immediate refund while allowing a larger amount of money to begin compounding for retirement.

However, the tax deduction is only part of the strategy. What you do with the refund can significantly affect whether the RRSP creates more after-tax wealth.

Can an RRSP Deduction Lower Your Taxable Income?

The RRSP deduction is a way to generate tax savings and receive a tax refund during the contribution year. The value of the deduction depends on your marginal tax rate.

A person in a higher tax bracket may receive a more valuable deduction than someone in a lower tax bracket. This is one reason a young worker who expects to earn more in the future may choose to defer claiming the deduction.

The goal is not simply to receive a refund. The goal is to use the RRSP tax deduction at a time when it creates the greatest long-term advantage.

The $10,000 RRSP Versus TFSA Example

Let's use an example of when the tax advantages may work using a $10,000 bonus.

In the example:

• The investor has $10,000 of pre-tax income.

• Their current marginal tax rate is 40%.

• The money will be invested for 35 years.

• The assumed annualized return is 7%.

• Their expected tax rate during retirement is 30%.

With a TFSA, the investor must first pay the 40% tax. That leaves $6,000 available for the TFSA contribution.

After 35 years at a 7% annualized return, the $6,000 grows to approximately $64,059. Because it is held in a tax-free savings account, the full amount can be withdrawn tax-free.

With an RRSP, the full $10,000 is invested.

After 35 years at the same assumed return, the RRSP grows to approximately $106,766. When the money is withdrawn at a 30% tax rate, the investor is left with approximately $74,736.

In this example, investing in an RRSP produces approximately $10,677 more in after-tax money than the TFSA.

The difference comes from investing a larger amount from the beginning and withdrawing it at a lower tax rate than the rate applied when the deduction was received.

Why Reinvesting the Tax Refund Matters

The RRSP example only works when the investor actually reinvests the tax refund or arranges for the full pre-tax amount to be invested.

If you make an RRSP contribution, receive a refund and spend that refund on a vacation or another purchase, the advantage can fall apart. In that situation, the TFSA may have been the better choice.

Reinvesting the refund gives the additional money an opportunity to compound over time.

The video compares this to planting an apple seed and continuing to water it. Spending the refund is like planting the seed, digging it up several days later and wondering why it never became a tree.

The refund should be treated as part of the retirement savings strategy, not as bonus spending money.

Withdrawing RRSPs and Managing the Tax Burden

An RRSP withdrawal is taxable.

This is one of the most important facts to understand before investing in an RRSP.

The tax deduction you receive today does not make the money permanently tax-free. It defers the tax until the money is withdrawn.

The eventual tax burden depends on how much you withdraw, your other taxable income and the tax bracket you are in at the time.

What Happens When Money Is Withdrawn From Your RRSP?

The Canada Revenue Agency may apply an immediate withholding tax of up to 30% before you receive the money.

The withdrawal is also treated as taxable income.

In addition, the contribution room connected to the withdrawn funds is permanently lost.

This can make an RRSP withdrawal particularly painful for someone in their 20s or 30s who needs money for:

• A job loss

• An emergency

• A vehicle repair

• An unexpected expense

• A short-term financial need

If you need flexible access to your money, the video suggests that a TFSA may be more suitable.

RRSP Withdrawals After Age 71

When you turn 71, you must convert your RRSP into a Registered Retirement Income Fund, or RRIF.

Once the RRSP becomes a RRIF, you are required to withdraw a set percentage each year, whether you need that retirement income or not.

The required RRIF withdrawal is taxable.

For someone with a large RRSP, those forced withdrawals may:

• Increase taxable income

• Push the retiree into a higher tax bracket

• Create a larger annual tax burden

• Trigger an OAS clawback

• Reduce the government benefits they receive

This is why retirement planning should include more than simply building the largest possible RRSP portfolio.

You also need a plan for how and when the money will be withdrawn.

Making RRSP Withdrawals Before They Become a Problem

Be careful of leaving a large RRSP untouched until death.

Instead, retirees may be able to actively reduce the future tax burden by making planned withdrawals while they are alive.

Spousal RRSPs, Spousal Rollovers and Income Splitting

What Happens to an RRSP After the First Spouse Dies?

One of the most common fears is that the government will immediately take a large portion of an RRSP when its owner dies. This does not automatically happen when there is a surviving spouse.

Through a spousal rollover, the RRSP or RRIF may transfer to the surviving spouse while remaining tax-deferred. According to the transcript, the major tax bill generally arises on the second death, when the remaining registered retirement savings pass to the children or estate.

This makes planning for an RRSP for couples different from planning for an individual with no surviving spouse.

Can Couples Split RRIF Income?

Once you turn 65, you may be able to split up to 50% of RRIF income with your spouse.

This can be useful when one spouse has a high income and the other spouse is in a lower tax bracket.

By shifting part of the RRIF income to the spouse with the lower tax rate, the couple may be able to:

• Reduce the higher-income spouse’s taxable income

• Keep both spouses in lower tax brackets

• Reduce the household tax burden

• Protect more of their OAS benefits

• Manage income in retirement more effectively

This income-splitting strategy focuses on RRIF income during retirement.

Who Should and Shouldn’t Invest in RRSPs?

RRSPs are not automatically the best account for every Canadian. Whether RRSPs are worth using depends on your current income, future income, need for flexibility, retirement tax rate and willingness to reinvest the refund. Questions? Reach out to Rankin Rice Wealth Management.

Who May Benefit From Investing in an RRSP?

An RRSP may be worth considering when:

• You are currently in a higher tax bracket.

• You expect to be in a lower tax bracket during retirement.

• You do not need immediate access to the money.

• You have a long time horizon before retirement.

• You will reinvest the tax refund.

• You have a plan for future RRSP withdrawals.

• You want to build long-term retirement savings.

• You understand that the withdrawal will be taxable.

• You are prepared to manage RRIF income after age 71.

For a high-income Canadian, an RRSP deduction may create meaningful tax savings today. If that person enters retirement in a lower tax bracket, the tax deferral can produce more after-tax wealth.

Who May Want to Delay an RRSP Contribution?

You may want to delay using your RRSP deduction when:

• You currently earn less than $60,000.

• You expect a higher income later in your career.

• You are currently in a lower tax bracket.

• You may need access to the money soon.

• You are building an emergency fund.

• You are saving for your first home.

• You do not plan to reinvest the refund.

• You expect to pay a higher tax rate when withdrawing the money.

Someone early in their career may still make an RRSP contribution and defer the deduction until a future tax year.

The key is matching the deduction to a year when your income and marginal tax rate make the tax benefit more valuable.

When a TFSA May Be the Better Choice

A tax-free savings account may be more suitable when flexibility is the priority.

Consider a TFSA when you may need the money for emergencies, job loss, vehicle repairs or other short-term needs. A TFSA contribution is made using after-tax money, but future investment growth and qualifying withdrawals are tax-free.

The stronger option depends on your circumstances. A TFSA may be more attractive when:

• You are currently in a lower tax bracket.

• You expect your income to increase.

• You need flexible access to your savings.

• You may need to withdraw the money before retirement.

• You are unlikely to reinvest an RRSP refund.

An RRSP may be more attractive when:

• You are currently in a higher tax bracket.

• You expect a lower tax rate in retirement.

• You can leave the money invested for decades.

• You will reinvest the refund.

• You have a withdrawal strategy.

Conclusion: Are RRSPs Worth It for Your Future?

So, are RRSPs really worth it?

They can be.

An RRSP can help you save for retirement, defer tax, receive a deduction and invest a larger amount of money from the beginning. When the deduction is claimed in a higher tax bracket and the money is withdrawn in a lower tax bracket, the strategy may produce significantly more after-tax wealth.

However, RRSPs can also create problems when they are used without a plan.

The potential disadvantages include:

• Losing contribution room after a withdrawal

• Paying withholding tax on money withdrawn early

• Increasing taxable income during retirement

• Being forced to make RRIF withdrawals after age 71

• Entering a higher tax bracket

• Triggering an OAS clawback

• Creating a large tax burden for an estate

• Spending the tax refund instead of reinvesting it

What makes RRSPs worth considering is not simply the refund you receive today.

The real value comes from coordinating your RRSP contribution, deduction, marginal tax rate, refund, investment period and retirement withdrawal strategy.

Before you contribute to your RRSP, ask yourself:

• Am I currently in a high or low tax bracket?

• Will my income be higher in a future tax year?

• Can I leave the money invested until retirement?

• Will I reinvest the tax refund?

• What tax rate might apply when I withdraw?

• Could my RRIF income create an OAS clawback?

• Do my spouse and I have an income-splitting strategy?

• Am I building a retirement plan or simply chasing a refund?

An RRSP is a financial tool, and a financial tool is only as effective as the strategy guiding it.

Watch the full video to hear Devin Rice explain how RRSPs work, why the common warnings are not entirely wrong and how Canadians can avoid turning their retirement savings into a future tax problem.

For personalized guidance, speak with a financial advisor at Rankin-Rice Wealth Management about your RRSP contribution room, expected income in retirement and whether your current registered retirement savings strategy is helping you build more after-tax wealth.