Using an RRSP as a tax deduction tool

Many people consider the Registered Retirement Savings Plan (RRSP) to be a must-have when it comes to saving for retirement. Almost six million Canadians contribute to one each year.

But did you know that the RRSP is also a powerful tax-planning tool? It pays to know about the RRSP tax deductions that you could use.

In last week’s column I talked about the upcoming RRSP deadline and to follow up, I wanted to share some more details on exactly how the tax deductions work and how to maximize those deductions.

When you contribute to an RRSP, any growth, such as through interest and dividends, is tax exempt for as long as you keep it in the plan. However, another big advantage is that your contributions lead to RRSP tax deductions, which will lower your overall tax burden in each year you contribute.

How does an RRSP tax deduction work?

Canadians are taxed on their net income, which is equal to their total income minus certain deductions, including RRSP tax deductions. These can result in significant tax savings.

Let’s look at an example: a single person living in B.C., with a total income of $120,000 and no deductions (including RRSP tax deductions), would pay combined federal and provincial tax of approximately $29,000.

If they made the maximum allowable contribution to their RRSP, this would be 18 per cent of their earnings, or $21,600 (for people earning over $154,611, the maximum contribution is $27,830 for 2021).

Their net income, therefore, would be reduced from $120,000 to $98,400, and the tax owing would be roughly $20,700, instead of $29,000. This RRSP tax deduction would mean they would pay $8,300 less in tax for that year.

But remember, this $8,300 of tax “savings” is really a deferral and the taxes on this money (and it’s growth) will be due down the road. So, if you take that $8,300 and go shopping the entire RRSP program doesn’t work. But if, instead, you put it against some debt or re-invest it in your savings, you’re on the right track.

How much should I contribute to RRSPs?

This will really depend on your income and other personal financial circumstances. If you’re earning a fairly low income, and therefore paying a low rate of income tax, an RRSP may not be the best option for you.

Contributing to an RRSP makes the most sense from a tax-saving perspective if your tax bracket when contributing is significantly higher than you expect it to be when you retire. If you have an average-to-significant income, making the maximum contribution of 18 per cent will allow you to receive the biggest tax refund possible, while saving a large amount for your retirement.

When should I save in a TFSA instead?

Depending on your current tax rate, it could make sense to save in a Tax-Free Savings Account (TFSA) rather than an RRSP. If your income and tax rate are low, a TFSA could be a better option because the income tax savings may be negligible. While you won’t benefit from RRSP tax deductions, your savings will still get to grow completely tax-free.

If you have maxed out your RRSP contributions, it would usually make sense to put your RRSP tax refund and any extra available money for saving into a TFSA. Given that your investments will grow tax-free, saving in a TFSA in these circumstances is a real no-brainer.

TFSAs are also more flexible than RRSPs: you can save up to $6,000 tax-free in a TFSA each year and, unlike with an RRSP, you won’t pay any tax when you withdraw funds. Therefore, if you need money quickly, for an emergency or large purchase, taking it out of a TFSA would not trigger a tax hit, unlike with an RRSP.

How does a spousal RRSP work?

A spousal RRSP is another potential tax-planning tool for high-income Canadians. These accounts are usually held in the lower-income-earner’s name, but the higher-earning spouse can contribute and receive the tax deduction for themselves. While this reduces the contribution room of the higher earning spouse, when the RRSPs are accessed in retirement, there will be two smaller incomes instead of one big income, so the couple can potentially save on taxes.

Getting started maximizing your RRSP tax deductions

It’s important to know that an RRSP is more than an efficient way of saving for retirement: it can also reduce your tax bill. And it’s always a good strategy to get your RRSP and TFSA working together to not only fund your retirement goals but also use them as effective tax-planning tools.

Speak to your financial planning professional to get the ball rolling - they can work with you to build a strategy that makes the most of your maximum RRSP tax deductions, while taking into consideration your TFSA options.

This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.