Dale Jackson

Personal Finance Columnist, Payback Time

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The rush to make a registered retirement savings plan (RRSP) contribution before the deadline (which falls on March 1 this year) is nothing new.

Canadians have been scrambling to sock away their retirement savings and lower their tax bills in the popular tax shelter since 1957. Aside from a few tweaks over the decades, the basics of the RRSP remain the same.     

How RRSPs work

RRSP accounts can be set up through just about any financial institution. Contributions can be deducted from taxable income in any calendar year going forward, but the deadline for it to apply to last year is March 1.

Contributions can be invested in just about anything; stocks, bonds, mutual funds, exchange-traded funds, options — whatever. You can even keep them in cash. 

Those investments can grow tax-free for decades until they are withdrawn; that’s when they are fully taxed — ideally at a low marginal tax rate in retirement.

The RRSP contribution limit for 2021 is 18 per cent of reported earned income in 2020, up to a maximum of $27,830. Unused contribution space can be carried forward to future years. 

The Canada Revenue Agency (CRA) keeps track and lists remaining contribution space on each year’s tax statement.    

RRSP strategy

Canadians love their RRSPs because contributions made before the deadline almost always result in lower tax bills in the spring. In cases where an employer makes payroll deductions throughout the year it usually results in a refund.

The size of the refund depends on how much taxable income you generate the year it is claimed, and your marginal tax rate as a result.

Here’s a simplified example: If you live in Ontario and earn less than $50,000, your combined federal/provincial tax rate is about 20 per cent. That means an RRSP contribution of $10,000 would lower your tax bill by 20 per cent, or $2,000.

If you live in Ontario and earn more than $250,000, your combined tax rate could top 50 per cent. An RRSP contribution of $10,000 at that marginal rate would lower your tax bill by 50 per cent, or $5,000.

If it seems like RRSPs favour the rich, you’re right. Tax savings for lower income Canadians are much smaller than those with higher incomes. One strategy that could level the playing field a bit is to make contributions when you can but only claim them in high income years.   

RRSP pitfalls

If you contribute to your RRSP at the lowest marginal rate, the best you can hope for is to withdraw savings at the lowest marginal tax rate in retirement. In that case, the only real advantage to an RRSP is tax-free growth over time.  

If you contribute a lot and invest well, and your RRSP savings grow above expectations, that’s a good thing — but it could put you at a higher marginal rate than your original contribution when it comes time to make withdrawals.

When you reach 71 years, Ottawa will impose minimum RRSP withdrawals, which could also result in Old Age Security (OAS) clawbacks if they reach a certain threshold.

If you make an early withdrawal while you are still working, the amount you remove from the plan will be taxed at whatever rate you are paying that year. If you are already taxed at a high marginal rate, the amount you withdraw could push you into an even higher tax bracket.

Early withdrawals could make sense if your income has been reduced, but you will lose that allowable contribution space forever. 

Ottawa also allows tax-free withdrawals for continuing education or to buy a first home, as long as the money is returned to your RRSP within a certain period of time.