Should You Retire from RSP Contributions?
While it’s called the Retirement Savings Plan (“RSP”), the government eventually gets their money.
Earlier this week, we had two back-to-back client conversations. Both are very similar in age. Each have the same number of kids. They even live not too far from each other in the same neighbourhood.
However, each person has opposite views about making an RSP contribution before the February 29 deadline this year.
Simply put, here’s how an RSP works. Contributions are generally made using your take-home pay. From there, you get a nice refund after your file your taxes. The refund is your contribution multiplied by your marginal tax rate. From there, the investments held inside your RSP will compound tax free.
What’s not to like?
Well, once you start to withdraw, that money is considered ordinary income and taxed at your marginal rate. While you got a nice refund making the contribution, you pay the taxes down the road.
Let’s return to those two clients we mentioned earlier. Aaron is the “RSP saver” and Kelly to the “RSP skeptic.”
Aaron likes getting that refund each year. Who doesn’t? He then uses that refund cheque to fund other purposes. For example, he mentioned his plans to direct his refund this year toward maxing out his Tax Free Savings Account (“TFSA”). After he contributes $7000, which is this year’s TFSA contribution limit, he’ll still have plenty of money left to take his family down to Florida during March break.
Aaron’s correct, for now. But, that RSP account has a huge tax liability waiting for the day he starts making withdrawals. The RSP only defers tax – it doesn’t avoid tax. Whether he needs the money or not, by age 72, we’ll have to convert Aaron’s RSP into a RIF. Money will automatically get withdrawn according to a scheduled proportion of the total account size, and that rate will climb each year as he gets older.
Thankfully, Aaron isn’t in this situation, but for a low-income Canadian family, the higher your ordinary income, the less likely you are to receive income tested benefits like the Guaranteed Income Supplement or Old Age Security because the claw backs are very hefty.
Kelly doesn’t want to deposit anything more into her RSP. Instead, she wants access to her money whenever she needs it. This is because she might want to buy another property down the road and rent it out. Kelly makes a good point. If she kept depositing to her RSP, she wouldn’t qualify for the two exceptions that permit a tax-free withdrawal. She would have to qualify under the Home Buyers Plan (on the condition it’s her first property, but that withdrawal is capped at $35,000 and Kelly would need to pay it back in 15 years) or the Lifelong Learning Plan should Kelly choose to go back to school. Unfortunately, Kelly’s bought her first property and doesn’t plan to be classmates with her children.
Kelly might be missing out. Kelly has always had a strong income and -- depending on your perspective -- she’s suffered/benefited from a high marginal tax rate. If Kelly’s working at 60, it will be because she wants to, not out of necessity. Kelly could deposit money into her RSP while she’s in a high marginal tax rate, retire early, and slowly chip away at her retirement account in a much lower marginal tax rate for the next several decades.
Aaron has a decent household income as well, but it’s variable and fluctuates all over the place. Aaron’s RSP contribution room is based on his gross income for the calendar year. He’s fell into the habit of only saving the RSP contribution limit written down on his Notice of Assessment each year. Therefore, in a year with lower income, he might not save enough. That’s not a problem this year, though. Aaron is coming off one hell of a good year. His income was well over $400,000 in 2023. However, CRA only allows him to contribute 18% of your income or $30,780, whichever is less. If 2024 is a horrible year, and let’s say his income drops 80%, he’ll only be allowed to contribute 18% of that amount.
Kelly is about to have a big chunk of change on her plate to allocate. She’s collapsing a holding company and will have well over six figures of money to allocate to her various investment accounts. Kelly’s accountant advised putting a big portion of it into her RSP.
“But if it’s in a non-registered account, don’t I get the dividend tax credit?” Yes, I said.
“Aren’t realized capital gains taxed at half my marginal rate?” Correct.
“And I get none of these advantages withdrawing money from a RIF because it’s all lumped into ordinary income and taxed at my full marginal rate, right?” Right again.
Not so simple a decision anymore, is it?
If you’re on the fence, one thing Aaron and Kelly both agreed on was to max out their TFSA. Studies show the TFSA holds its own against an RSP when extrapolating the value of contributions over time after-tax.
Making decisions like these is made easier when working with a firm that takes an interest in your personal situation. Schneider & Pollock Wealth Management Inc. tailors its advice to every client, right down to whether an RSP contribution makes sense, and if so, how much to deposit.
*While Aaron and Kelly were inspired by real-life clients and their situations, several characteristics of each personality was materially altered to provide additional context to the RSP’s many features.
-by Jeff Pollock
DISCLAIMER: The opinions expressed in this publication are for general informational purposes only and are not intended to represent specific advice. The views reflected in this publication are subject to change at any time without notice. Every effort has been made to ensure that the material in this publication is accurate at the time of its posting. However, Schneider & Pollock Wealth Management Inc. will not be held liable under any circumstances to you or any other person for loss or damages caused by reliance of information contained in this publication. You should not use this publication to make any financial decisions and should seek professional advice from someone who is legally authorized to provide investment advice to assess your goals and objectives, personal circumstances, and make an informed suitability assessment.