The proper use of RRSPs: the one formula approach

No matter what time of the year it is, one of the most popular questions I get is whether it makes sense to buy a RRSP? I remember coming out of University and my father telling me I should invest in RRSPs for retirement. When I asked him why, he simply said “It’s a good investment.”

Now after being in the financial industry for 20 years, I realize that there are a lot of people who bought RRSPs but don’t really know why. Most people buy RRSPs for the tax deduction but that’s a little short sighted. There’s a little more to making good RRSP decisions than just getting a tax deduction. Remember that somewhere down the road, when you take the money out of the RRSP, you then have to pay tax right back to the government. So how do you know if you should buy RRSPs? How do you know if you are using RRSPs properly? How do you know if buying RRSPs is better than the Tax Free Savings Accounts (TFSA) or paying down debt?

Here’s my very simple formula to help you use RRSPs properly:

So what does all this mean? Firstly, you need to know about marginal tax rates. Marginal tax is simply the amount of tax paid on an additional dollar of income. As income rises, so does the tax rate.

Marginal Tax

For 2010 the tax rates for Alberta and Federal tax combined are:

$0 to $10,382 = 0%
$10,383 to $16,775 = 15%
$16,776 to $40,970 = 25%
$40,971 to $81,941 = 32%
$81,942 to $127,021 = 36%
$127,022 and up = 39%

Your marginal tax rate determines the immediate benefit for the RRSP. For example, if I made $25,000 last year, my wife made $50,000, and you made $100,000 and we each decided to invest $1000 into the RRSP, I would save $250 in tax, my wife would save $320 and you would save $360 in tax. Despite investing the same $1000 we all get different tax benefits depending on our marginal tax rate.

For marginal tax rates for provinces other than Alberta, check out my annual tax rate card.

What will your marginal tax rate be when the money comes out?

Not only do you need to know what your marginal tax rate is at the time of contribution but it would be advantageous to do some projections to see what your marginal tax rate might be when you are going to take the money our of the RRSP.

Obviously, the ideal situation is to invest the money when you are in the highest marginal tax rate and then take the money out when you are in the lowest marginal tax rate. Let’s say, you are in a 39% MTR and you invest $1000 into the RRSP. The government gives you $390 as a result of that RRSP contribution. But the government does not really give you the money, they are lending you the money because when you take $1000 out of the RRSP, then you have to pay tax. But if you are in a 25% MTR when you take the money out, you do not have to pay back the $390, you only have to pay back $250. That’s a 14% benefit on top of any investment returns you may have made. That’s how to use the RRSPs properly and to your advantage.

On the other hand, you would be doing yourself a disservice if you put money in while you are in the lowest tax bracket and then taking it out in a higher tax bracket. Imagine putting in $1000 into the RRSP when you are in a 25% MTR but taking it out when you are in a 32%, 36% or 39% MTR. That’s giving the government more of your hard earned money.

How long before you draw money out of an RRSP?

In this equation for evaluating the use of RRSPs, I have not considered the compounding effect of the tax-deferred income inside the RRSP. When you make money on the investments, you do not have to pay tax on the growth as long as the money stays inside the RRSP. The more time you have, the more valuable tax deferral and compounding become. For example, someone who is young and just starting to work may not be in a high tax bracket. Although their best earning years are ahead of them and they may be in higher tax brackets down the road, I would argue that the compounding effect of a long term tax deferral outweighs the value of the tax deduction.

My advice to young people is to develop a long term savings habit by putting money into their RRSPs on a regular basis. Developing the habit of saving for the future instead of saving to spend is the best financial habit that you can develop.

As you can see, most Canadians will benefit from using RRSPs. The value of the RRSP is not only determined by the tremendous tax deduction at the time of contribution but also other factors like your marginal tax rate at the time of withdrawal, the investment return over time, what you might invest in (capital gains vs interest vs dividend income), etc.

In some cases, the RRSP will not make sense. In the end, the decision to buy RRSPs is a personal one. Ideally, the decision is made by developing a plan and doing some future income projection. Good luck!