Focus on tax rate for RRSP planning
An RRSP works best when your tax bracket is lower in retirement than when you make your RRSP contribution.
First, understand how income tax brackets work. See the federal tax brackets on Schedule 1 of your income tax return. They are like steps on a stairway. You pay taxes at a different rate for each step, as your income climbs the steps.
For RRSP planning purposes, focus on the tax rate for the highest step that your income reaches.
Tax brackets in 2015
On your first $44,701 of taxable income, you pay the lowest rate of tax (26 per cent when you include Saskatchewan tax).
For 2015, the second bracket starts at $44,701. You pay 35 per cent on the next $44,701 layer of your taxable income.
For the third bracket, the 39 per cent tax rate starts at $89,401.
The highest bracket (44 per cent) applies to income over $138,586.
Most retired Canadians have taxable incomes below $44,701. Those retirees can expect to be in the lowest (26 per cent) tax bracket while they are drawing income from pensions and RRSPs.
Because of pension splitting, even retirees with good company pensions may stay in the lowest bracket if they have a low-income spouse. Drop to lower tax bracket
We’ll look at using an RRSP for someone who consistently earns more than $44,701 during the working years, and then reports income of less than $44,701 per year during retirement.
A Saskatchewan worker with an average wage of $51,792 would have a $350 tax deduction for a $1,000 RRSP deposit and then pay only $260 income tax on the $1,000 withdrawal, later in retirement. Indeed, thanks to the federal and provincial pension tax credit, there would be very little tax on the first $2,000 of RRIF withdrawals after age 65.
Thus, you can profit from using an RRSP to defer income from working years, when you are in a high bracket, until retirement when you are in a lower bracket. Climb to higher bracket
On the other hand, what if you are a worker with 2015 taxable income below $44,701? You are in the lowest tax bracket. Like many workers you may have no employer-sponsored pension plan benefits and only a small RRSP. Possibly your retirement income level will be low enough to qualify for some Guaranteed Income Supplement (GIS).
If you are single and 65 or older, you can be eligible to receive GIS if your total annual income is below $23,981. (Note that I am including basic Old Age Security income.) Maximum GIS is $773 per month.
The GIS benefit is income tested. For every dollar of additional income that you earn, your GIS benefits will be reduced by 50 cents. Effectively, that is equivalent to being in a 50-per-cent tax bracket.
It is counterproductive for a low-income worker to get a 26-per-cent tax saving from the RRSP contribution and then face the 50-per-cent GIS income test on top of a 26-per-cent tax rate on withdrawals from the RRSP savings. An RRSP won’t help much if you climb to a higher bracket in retirement.
A low-income worker should build a Tax Free Savings Account nest egg because those TFSA withdrawals don’t count in the GIS income test. 2016 bracket reduction
If you’re in the second tax bracket (earning between $44,701 and $89,401), an RRSP contribution at this time next year would save tax at only 33.5 per cent. That means you are better off getting a 35-per-cent deduction for 2015 rather than waiting a year.
The 2015 RRSP contribution deadline is Feb. 29, 2016. Terry McBride, a member of Advocis, works with Raymond James Ltd. (RJL). The views of the author do not necessarily reflect those of Raymond James Ltd. (RJL). Information is from sources believed reliable but cannot be guaranteed. This is provided for information only. We recommend that clients seek independent advice from a professional adviser on tax-related matters. Securities offered through Raymond James Ltd., member of the Canadian Investor Protection Fund. Insurance services offered through Raymond James Financial Planning Ltd., not a member of the Canadian Investor Protection Fund.