I often see the notion of waiting until your income increases before contributing to your RRSP. I understand the general idea of waiting to get a bigger tax break when I’m earning more, but think it’s ridiculous because I would much rather get money back now from contributing to my RRSP. Then I can reinvest that money over a time frame (say 10 years). Isn’t that better than waiting 10 years until I’m earning a higher income?
I can certainly see the logic here. Isn’t it better to start contributing to an registered retirement savings plan (RRSP) now and collect an income tax refund from your deposits, which you can then roll back into your RRSP, compounding the benefits? That sounds better than waiting ten years and then trying to catch up later, when your income is (hopefully) higher.
In these situations we can, and probably should, run some numbers to see what your RRSP investments would do for you if you invested now versus investing later. Depending on how much your income goes up in the next decade or two, and how much of that income you can invest, you may come up with different conclusions as to when it is beneficial to start contributing to your RRSP.
I’ll come back to some example numbers later. For now I want to highlight a bigger factor: what is your alternative to the RRSP?
In the choice mentioned in the above question, there is the issue of whether to put available money into an RRSP now or wait until later. What is missing from our decision making process is deciding what is done with the money if it is not put into an RRSP. Is it invested in a tax free savings account (TFSA)? Are we going to put the money into an index fund? Into a guaranteed investment certificate (GIC)? Are we investing the money in real estate? Is it left sitting in a savings account? Or maybe it’s invested into a business?
In short, the question is not just be whether it makes sense to stuff money into an RRSP now, when making a lower income, or later at a higher income. We should be considering whether an RRSP now is better or worse than other investments we could be starting.
Let’s look at an overly simplified pair of scenarios to try to illustrate why one approach might be better or worse than another. This will be a crude example, using nice, round, made-up numbers for income and tax rates and it is not to be taken as literal. This is just for illustrative purposes to get a sense of why one approach might be more beneficial than another.
Let’s imagine that for the next ten years you make $50,000 per year and are taxed at 30%. Let’s also assume that ten years from now you suddenly get a raise to $100,000 per year and are taxed at 50%. You then work this second job for another ten years. So we’re looking at a 20 year time-line in total, half with an income of $50k and half making $100k.
Now, let’s look at two investment options. In the first, we invest in an RRSP non-stop, putting 10% of our income in each year. This will result in a tax credit which we then roll back into the RRSP fund. In the second scenario we put 10% of our income into a TFSA during the first ten years. Then switch over to an RRSP in the second decade. What results can we expect?
In the first scenario, where we put money into the RRSP non-stop we deposit $50,000 of our pay into the RRSP, plus about $18,000 in tax credits over the first decade. So our RRSP holds about $68,000, plus any interest it makes. In the second decade we deposit an additional $100,000 of our own money and end up rolling about $80,000 in tax credits back into the fund, for a total of $180,000 in the second decade. Combined, using the RRSP exclusively nets us an account holding $248,000 in deposits. There would be interest generated from the fund the RRSP invested in, but let’s ignore that for a moment, for simplicity’s sake.
When you go to withdraw the money, you’ll probably be retired and pulling out just enough money to live on. In other words, you’ll probably withdraw at a lower income bracket, let’s say 30%. When you withdraw the $248,000 you’ll lose 30% to taxes, meaning you’ll get to enjoy the remaining $173,600. This isn’t too bad, you put $150,000 of your paycheque into the fund and got back out $173,600, thanks to the power of tax credits.
In the second scenario, let’s put the $50,000 dollars we want to invest in the first decade into a TFSA. The TFSA doesn’t give us any tax credit for putting money in, meaning we don’t get to roll our tax credits into it. However, the TFSA also doesn’t charge us tax when we withdraw money either, saving us some pain in the future. Then, in the second decade, we switch over to using the RRSP and deposit $100,000 along with $80,000 in tax credits. In total, we’ve invested $150,000 of our money and been aided by $80,000 in tax credits, totalling $230,000. We’re short about $18,000 ($248,000 vs $230,000) in total investments in this second scenario, but we haven’t withdrawn the money yet.
When we withdraw the money, we get the $50,000 in our TFSA back tax-free. Plus $126,000 from our RRSP. In total, we get to enjoy $176,000 in our retirement. In other words, taking the mixed approach and using a TFSA when we’re earning less money and then switching to an RRSP when we’re making more money nets us an extra $2,400 with the same amount of our paycheque being invested in both situations.
As mentioned above, these calculations ignore the fact our investments should be accumulating interest over time. It also ignores that most people don’t make fixed incomes for a decade and then suddenly jump to a new tax bracket and start doubling their rate of investments. It’s a crude example. However, I think it serves to demonstrate why people on career paths that expect to make more money later in life hold off on using RRSPs. Using a TFSA can be helpful, especially when you’re in a lower tax bracket because, while you might put less total money away in the near future, you save more on income taxes later.
Something people can lose sight of is RRSPs do not offer a tax credit, they offer a tax deferral. You still pay taxes on the money you put into the RRSP, you just put it off until the money is withdrawn. In the long term RRSPs help you more when your tax rate is higher when you put money in and lower when you take it out. If you’re putting money into an RRSP when your tax rate is low, you’re not really befitting any more (in the long-term) than you would by putting the money into a tax free savings account – it’s just delaying when the taxes are paid.
What you likely want to do is put money into an RRSP when you stand to avoid the most income taxes and then withdraw when you’re in the lowest possible tax bracket.
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