RRSPS all about tax brackets
The months of January and February are traditionally known in the financial industry as “RRSP season” since you have only until March 1, 2013 to make a contribution if you want to claim a deduction on your 2012 tax return.
When we make an RRSP contribution, what are we really doing? We are effectively setting aside some of our income for consumption at a later date, which for most people, is retirement.
The government, through the RRSP system, gives you two incentives to encourage you to defer consumption to a later period in your life, in an attempt to smooth out your earnings among the years of employment through the years of retirement: a tax deduction for your contribution and the ability to earn what is effectively “tax-free” investment income on your after-tax contribution.
While many people cite the tax deduction as the main advantage of contributing to an RRSP, it’s only worth something if you find yourself in a lower tax bracket at the time of withdrawal than you were in the year you made the contribution. Otherwise, the tax deduction itself is worthless and the only tax advantage is the ability to earn effectively tax-free investment income.
Why is the deduction worthless, you ask? After all, isn’t paying the CRA later better than paying today?
Not really, because the tax man effectively charges you “interest” on the fact that you have delayed paying him for so many years. The interest rate you pay is the rate of return on your RRSP savings.
For example, let’s say Sarah faces a 40% marginal tax rate in 2012 and contributes $1,000 to her RRSP by the March 1 deadline, choosing to pay tax on this amount some day down the road, when she withdraws it. She will save $400 in taxes otherwise payable for 2012. Let’s assume the funds are invested for 10 years at an annual compounded rate of return of 3% such that by January 2023 her RRSP will have grown to $1,344. If she withdraws the money at that time and her marginal tax rate is still 40%, she will hand over $538 to the taxman.
We can think of the $538 payable in 2023 as a combination of the $400 of taxes she owed on her 2012 income, but never paid, and $138 of compound “interest” at 3% that she must pay the CRA for privilege of deferring taxes for 10 years.
Of course, had Sarah’s marginal tax rate been lower in the year of withdrawal (2023) than in the year of contribution (2013), she would actually reap a tax benefit from the deduction.
For many, however, the true advantage of contributing to an RRSP (or a TFSA, for that matter) is the ability to earn what effectively amounts to tax-free investment income on our net contribution. In Sarah’s case, her net contribution was $600 and at the end of 10 years, she will keep $806 after tax ($1,344 RRSP value withdrawn less $538 of taxes paid) for an effective “tax-free” compounded rate of return of 3%.