How do you know if maximizing your RRSP contributions this year is a good idea?
The mutual fund industry will always tell you to maximize, maximize and maximize, despite your personal circumstances. What they fail to mention is that this can lead to massive tax bills on your estate, when almost half of your RRSP/RRIF funds can go to the government in taxes (as the government taxes it as “income earned in one year”)!
The key to avoiding this tax situation lies in how you contribute to your RRSP on a yearly basis. The general idea here is that you should maximize your RRSP in the years when you can save taxation this way. In the years when you have a low tax bill, you should avoid putting anything in your RRSP. This way, you can get the best combination of lower taxes both now and in the future.
For any particular year, these are the three key questions to ask yourself:
1. What is the tax refund I will receive on each dollar of RRSP contribution?
If you are in a higher income year, you will be receiving a higher tax refund (i.e. for $127,000 of taxable income, the refund is 46 cents per dollar). Here, you will want to maximize your RRSP contributions to enjoy less present taxes and allow your money to grow tax-free until retirement.
2. What will my tax bill be when I take money out of my RRSP/RRIF?
If you are in a lower income year, then your present tax bill will be fairly low. If you are maximizing your RRSP contributions every year in this situation, then you are simply creating a higher tax bracket for yourself in the future. Consider what your future tax bracket will be in your RRSP/RRIF years, and if this is higher than the present tax bracket, then do not contribute to your RRSP.
3. How much time will the RRSP be able to grow tax-free?
Generally, the younger you are (with a decent income), the more you can benefit from long-term tax free growth so RRSP contributions are encouraged. However, if you are earning less than $40,000 (similar to question 2), consider an alternative like the TFSA.
Remember that RRSP contributions depend on your personal situation and can change from year to year. Speaking to a trusted financial advisor can help you make the most of these tax minimization strategies.
One quick and free tool can be found on our website. The Tridelta Retirement 100 helps you see your likelihood of running out of money, your likely estate size and lifetime tax bill. By playing with RSP numbers, you can see the impact yourself.