Four strategies to optimize RRSP savings
What is an RRSP?
A registered retirement savings plan (RRSP) is used to:
Save for retirement
Enhance retirement planning
Split retirement income with a spouse
Help decrease taxes payable each year
RRSPs are a tax-deferred account you can contribute to based on earned income – up to 2021’s yearly maximum of $27,830. Earned income includes employment and self-employment earnings plus other income, minus employment expenses and business or rental losses from the previous year.
Contribution amounts are carried forward indefinitely if not used or deducted in any taxation year. A tax deduction becomes available in the year of contribution. It can be used to offset taxes payable on your personal income tax return in that year or any future year. You can contribute into an RRSP any time during the year, including the first 60 days of the year following the tax year.
All investment growth and income earned within the RRSP accumulates tax-free. All tax is deferred until money is removed from the account, at which time the amount is fully taxable at your marginal tax rate. This can be very powerful when your marginal tax rate is high in the years when making contributions and lower in the years when the funds are withdrawn.
4 strategies to contribute to an RRSP
1. Lump-sum deposit strategy
This strategy is straightforward. It represents any after-tax money your clients wish to contribute into their RRSP. A tax deduction is available for the taxation year in which money was contributed into the RRSP.
Example:
Initial RRSP contribution: $5,000
Tax refund based on marginal tax rate of 40%: $2,000
Total RRSP contribution: $5,000
2. Reinvestment strategy
This strategy is like the one above but includes an additional contribution from the tax refund generated by the original RRSP contribution. Once the tax refund is received based on their lump-sum deposit, your client can contribute that amount into their RRSP account. This will also provide an additional tax deduction in the following year.
Example:
Initial RRSP contribution: $5,000
Tax refund based on marginal tax rate of 40%: $2,000
Total RRSP contribution: $7,000
3. Catch-up loan strategy
Your client can borrow money for an RRSP loan or to catch up on available contribution room, which is on their notice of assessment. Your client may want to use the catch-up strategy if they’re in a particularly high-income earning year. They can use the tax refund to pay back the loan. Depending on the size of the loan this can take a few months or years.
Example:
Initial RRSP contribution: $5,000 (client’s investment) + $5,000 (loan) = $10,000
Tax refund based on marginal tax rate of 40%: $4,000
Total RRSP contribution: $10,000
4. Gross-up strategy
The gross-up strategy expands on the previous strategies. The client borrows an amount equal to the expected tax refund prior to the contribution and uses the actual tax refund to repay the loan. This strategy will require knowledge of the desired contribution amount, their marginal tax rate, and the calculation of the expected refund to be generated by the RRSP contribution. It will also require an RRSP line of credit to be available to borrow the expected refund amount so the full amount can be contributed into the RRSP.
The following formula can be used to calculate the amount to borrow:
(RRSP contribution amount x marginal tax rate) / (1 - marginal tax rate) = gross-up amount to borrow
Example:
Expected tax refund: $5,000 x 40% = $2,000
Gross-up amount to borrow: $2,000 / (1 - 40%) = $3,333
Total RRSP contribution: $5,000 + $3,333 = $8,333
Initial RRSP contribution: $8,333
Tax refund based on marginal tax rate of 40%: $3,333
Total RRSP contribution: $8,333
Considerations
There’s always a risk when using borrowed money to invest.
Interest charges should be minimal, as the loan is expected to be outstanding for only a few months at the most. The interest when borrowing to invest in an RRSP isn’t deductible. The tax refund shouldn’t be spent. It should be used to pay off the loan to avoid more interest charges.
Did you make any RRSP contributions allocated (or repayments) to the Home Buyers’ Plan or the Lifelong Learning Plan? They’re considered separately from the above strategies. These repayment amounts are not considered RRSP contributions for purposes of generating a tax refund.
Summary
With appropriate planning, there are many ways to help you plan your RRSP contributions. New investors may feel more comfortable starting with a lump-sum contribution. More experienced investors may be more interested in the grossed-up strategy, which includes contributing their expected tax refund up front. Whether you are trying to maximize your RRSP contribution each year, make catch-up contributions or take advantage of excess RRSP contribution room, you have the power to determine your RRSP outcome.
This material is for information purposes only and should not be construed as providing legal or tax advice. Reasonable efforts have been made to ensure its accuracy, but errors and omissions are possible. Using borrowed money to finance the purchase of securities involves greater risk than a purchase using cash resources only. If you borrow money to purchase securities, your responsibility to repay the loan and pay interest as required by its terms remains the same even if the value of the securities purchased declines. Investors should only borrow money to make such an investment if they have the financial resources to assume the risk of the loss of their investment as well as the repayment of any such loan. All comments related to taxation are general in nature and are based on current Canadian tax legislation and interpretations for Canadian residents, which is subject to change. For individual circumstances, consult with your legal or tax professional. This information is provided by The Canada Life Assurance Company and is current as of December 2021.
