RRSP Strategies

This article on RRSP strategies is intended for those with basic understanding of RRSPs. If you need more basic information, check out  RRSP Basics.

As that article states, the one major benefit of an RRSP is tax deferment. If we can reduce our income when it is high, and increase our income later when our other earnings are low, then we save taxes. That’s a critical part of success in living a more wealthy lifestyle. Here are three example strategies to use income (and tax) deferment. 

1. The Registered Sabbatical Plan?

What if there were a faster way to save for a sabbatical? Turns out that building up an RRSP to take a significant time away is a great idea! If you earn $70,000 a year, then contributing $10,000 a year to an RRSP would save around $2,800 in taxes each year, depending on the province in which you live.

After 3 years, there would be $30,000 plus earnings in the account. This money can be withdrawn as an entire year’s income for a calendar year’s sabbatical. Each individual withdrawal should be $5000 or less to keep the tax withholding to 10%. At the end of the year your taxes owing would be around $3000. You would have already contributed that amount through the withholdings!

What’s the total benefit here? Money went in at about 28% tax savings, and came out at an effective 10% tax rate. This means an additional 18% of the contributions went into funding your sabbatical, as compared to saving outside an RRSP. A reminder that $10,000 pre-tax invested in the RRSP would be $7200 after tax invested otherwise. $2800 a year invested at 6% a year would be $9,450 at the end of 3 years. This means extra monthly cash flow of just over $700 after tax withholding compared to saving in a non-registered plan!

2. The Late Career Top Up

As indicated in the RRSP Basics article, unused RRSP contributions can be carried over to be used in future years. My personal opinion is that RRSPs should NOT be used until our income is significantly higher than the first federal tax bracket. This opinion changes a bit in the last few years before retirement. Even a tax savings of as little as 8% is significant over a couple of years. 

This strategy applies to those  expecting a significant income drop after retirement. The strategy is to use borrowed money to reduce the income of the last 3 working years. There is benefit to lowering the income down to the cutoff of the first federal tax bracket  – currently $57,375. Do not borrow to lower the income any further as there is a financial loss equivalent to the borrowing interest rate.

A note of caution that using borrowed money always adds to the overall riskiness of any investment. Please review the strategy with an advisor prior to implementing it.

A Monetary Example

John is a BC resident earning $125,000 a year and plans to retire in 3 years. His spouse has no RRSPs, and will retire at the same time. To get down to $57,375 in income, John could borrow up to $68,000 each year to contribute to his RRSP. If his house has a low mortgage, John can set up a $200,000 line of credit. Using the house as collateral, John should get a rate near the floating mortgage rate, currently around 5%. 

The borrowing cost for the first year’s contribution is $68,000 x 5%, or $3400. This first loan withdrawal is at the end of the first year, coinciding with income tax filing. The payments on the loan start in the second year. The taxes deferred in the first year by this RRSP contribution are more than $19,000! Certainly worth checking out. Note that the interest for borrowing money to contribute to an RRSP is not an income tax deduction. Depending on your financial situation, your advisor may have options to make the borrowing tax deductible. 

An additional $68,000 is borrowed at the end of the second and third years. The interest expense in the third year is $6970, if the first year’s tax return was not used to pay down the loan or pay the interest. At the end of the third year, another $68,000 is borrowed.

So the minimum savings pre-retirement is $57,000 in taxes. We have a loan for $214,370, and an asset of $204,000 plus any returns on the investment. If the tax return pays down the loan, then the loan amount at retirement time would be $144,150.

After Retirement…

When the money is withdrawn from the RRSP, the couple can split the income. The first $114,750 in income would be taxed at an effective rate of 20.8% if the couple defers other income. The after tax income is $90,882. The second year would provide income of $81,000 at the same tax rate. The total tax liability is $40,000. The actual reduction in taxes is $57k minus the $40k paid later, or $17,000 extra for the couple. 

Interest on the loan for the 2 years to pay it back is an additional $9750 – making the a profit of $7250 with a nearly risk free plan! Investment returns on the investment add to the total benefit!

3. Income Splitting

As referenced in the example just above, RRSPs can be used for income splitting during retirement. Money contributed to an RRSP during a marriage is legally considered to be a marital property. The government now allows spouses to split the income derived from RRSP withdrawals after the  retirement of the contributor. But, similar to the sabbatical plan, we don’t need to wait until retirement to take advantage of RRSP based tax deferral. We just need to plan far enough in advance.

Consider a couple planning to start a family in a few years. The prospective mother plans to take time off to be with the newborn. The lack of income might force the mother back to work earlier than planned, unless some advanced planning happens. It the mother’s current income is above the first tax bracket, then the mother can contribute to her own RRSP plan using the same concept described in the Late Career Top Up above. If her partner’s income is above the first tax bracket, then the partner can contribute in a similar fashion to a Spousal RRSP to reduce annual taxes before the child arrives. The spousal plan has the mother as the owner, and the partner as the contributor.

In most cases the mother will have a income which is in the first tax bracket while she is home with the baby. For the mother’s own plan (where she contributed in her own name) she can withdraw the money whenever she needs it during her time with the baby. For the spousal plan, there ARE restrictions. Currently, there must be two full tax years between the last contribution to any spousal plan and the first withdrawal by the mother. To make that clear, if the partner contributed to a spousal plan in tax year 2024, then the mother can withdraw the funds without concern beginning in 2027. Earlier withdrawals will be considered income for the spouse, not the mother.

If withdrawals are made earlier, then the income from the withdrawal is assigned back to the partner, eliminating any savings from the contributions made to the fund.

To maximize the benefit of this plan, the couple should contribute as much as possible to the Spousal plan. Potentially a good strategy might be to borrow money to contribute more. Then in the two years prior to starting the family, the couple should maximize the contributions to the mother’s own RRSP.

A Final Caution

As always, anyone considering these ideas (or any tax strategy) should talk to their accountant.  The rules affecting RRSPs are continuously evolving.