The conventional view serves to protect us from the painful job of thinking.
Update: This article was included in the Canadian Personal Finance and Investing Carnival #14. Thanks!
January is already coming to a close and February will soon be upon us. In the Canadian financial realm, that usually means a mad dash by financial advisors and journalists to remind us that we only have a few weeks left to make the obligatory contribution to our RRSP, or face the reality of dining on Tender Vittles in our golden years. This year, however, there seems to be a bit of an RRSP backlash, with more than one article taking a not-so-fast tone to contrast the steady “RRSP now” drumbeat pounded out by some members of the financial services industry and media.
Recently, Jon Chevreau of the Financial Post reviewed a report by CIBC Wealth’s vice president of tax and estate planning, Jamie Golombek. The report said that some Canadians may be too quick to jump into the RRSP instead of a TFSA (Tax Free Savings Account) because of the up-front tax refund. Many forget that we still need to pay taxes on that RRSP money when we withdraw it, and that it will be included in our income at the time. That can result in clawbacks to government benefits like GIS (Guaranteed Income Supplement) or and OAS (Old Age Security).
So maxing out your RRSP contribution may not always be the best course of action. To be sure, it’s a great idea if you happened to have a very high income in the past year, or if you received some kind of one-time bonus or windfall. But it’s not always the optimal choice, especially since the introduction of the TFSA.
The Most Important RRSP Question
For me, the number one question to ask yourself before you put money into an RRSP is the following:
What is the likelihood that you will pay less tax on that money when you withdraw it than you would now?
If it’s likely your tax rate will be lower when you take the money out, then by all means, contribute some cash. But if you’re pretty certain your tax rate might be about the same or higher, then it makes more sense to invest that money outside an RRSP.
5 Reasons to Skip the RRSP Contribution this Year
There are several reasons why you might want to temporarily exit the RRSP highway this year:
1. You’re in Debt
- If you have credit card debt, it’s probably costing you about 20% a year in interest. You’re better off paying off that debt first.
- If you’ve taken on a little more house than you can afford, you might be concerned that a rise in interest rates might make your mortgage unaffordable. Why not pay down the mortgage instead of contributing to you RRSP? It provides a guaranteed, tax-free return at your mortgage rate.
- If you have a car loan, consider the interest you’re paying. Would it make more sense to pay off the car?
- If you had higher income last year and you really want to take advantage of the tax refund an RRSP contribution will provide, go ahead and make the contribution, but make sure you apply the refund to your debt.
2. You’re Young
- If you’re in your 20′s or even your 30′s or 40′s, there’s no way of knowing what the tax laws will look like when the time comes to withdraw money from your RRSP. What if the tax rates are even higher then?
- Rules surrounding RRSPs and retirement could change by the time you retire.
- You probably have a lower income if you’re just getting started. In that case, it makes more sense to max out your TFSA contribution room and pay down debt first.
3. Lower Income
- Perhaps you’re income wasn’t that high last year. In that case, it’s better to save your contributions for a time when your income is higher.
- If you’re concerned about losing your job or you’re in sales or self-employed and you had a slow year, you may want to put your savings for the year outside an RRSP in order to have better access to the money in case you need it. (If you needed to withdraw the money from an RRSP, you would have to pay tax on that money.)
4. You Have TFSA Contribution Room Available
- If you have some TFSA contribution room left, you may want to max that out first and then put the remainder in an RRSP, depending on some of the other factors mentioned here.
- Money earned in a TFSA is completely tax free when you withdraw it, and it has no effect on income-tested government programs like GIS and OAS.
5. You Already Have a Lot of Money in Your RRSP
- Obviously, you shouldn’t contribute more than the amount allowed by your RRSP contribution limit.
- If you have a good chunk of change in your RRSP and you’ll also be receiving a substantial pension in retirement, it’s probably a good idea to take a look at the tax implications. If your tax bill is going to be very heavy in retirement, it might be time to lighten up on the RRSP contributions and consider some non-registered investments or savings products.
If you’d like another take on this, Jim Yih recently wrote a great article on The New Debate Between RRSPs vs. TFSAs.
Are you contributing to your RRSP this year, or taking a break to focus on other priorities?
(Photo Credit: ARENA Creative)