Let's talk strategy.
In this post we will define and discuss the term "topping up to bracket", and discuss how it may be a good strategy for you to pay fewer taxes.
We hear a lot about Registered Retirement Savings Plans (RRSPs), especially between the months of December and February every year. The reason is that as Canadian taxpayers, the deadline for RRSP contributions to be attributed to any tax year, is 60 days into the new tax year. For example for the 2021 tax year (which is from January 1st until December 31st 2021), we can actually make RRSP contributions as late as 1 Mar 2022, and attribute those contributions against our 2021 income taxes. Banks want your money, so they push you to make contributions during this extra 60 days.
As usual, because I'm not a certified financial planner or accredited tax expert, I need to disclaim that the contents of this article are my opinion only and should not be taken as individual financial advice catered to any one person. Every case is unique and if you are considering following any of my strategies or advice, you should seek an informed second opinion or at least adapt the ideas to fit your individual case.
Before getting into the strategy it's worth doing a review of a few key relevant points about RRSPs. These include: contribution room, how we save taxes on a contribution, and determining when making an RRSP contribution is a good move.
Contribution Room.When you earn and declare income, you gain RRSP contribution room;
- Unused contribution room carries forward to future years;
- If you have a job with a pension plan benefit, your RRSP contribution room may be reduced;
- If you withdraw money from your RRSP, you do NOT get that contribution room back in the future; and
- You can find out how much contribution room you have by looking at your Notice of Assessment from when you last filed your income taxes.
How you save taxes when you contribute to your RRSP.
- You pay taxes on the money you earn. When you contribute to your RRSP, you are reducing the amount of income on which you have to pay tax;
- The amount of tax you pay on your income is dependent on your tax bracket. For more discussion on tax brackets, see the "How to understand marginal tax rates" article. Simply put, the higher your tax rate, the more tax you will save in the year of an RRSP contribution; and
- While your money is still invested in your RRSP you will not pay taxes on investment income like interest, dividends, and capital gains. This allows your money to grow tax-free until you withdraw.
When you pay taxes
- When you withdraw from your RRSP, you pay taxes on the withdrawal at your marginal tax rate. So if you make the withdrawal when you income is otherwise low, your tax payable will be low. If you withdraw during a high-income year, your tax payable will be high;
- The best way to leverage the tax-saving power of an RRSP is to make contributions when you are earning high income, and make withdrawals when you are in a lower income; and
- For withdrawals, there is no distinction between earned income, interest income, dividends, or capital gains. The whole withdrawal gets taxed as earned income (this is an unfortunate down side, as it negates some of the preferential tax treatment on some types of investment income, like capital gains and eligible Canadian dividends).
Great. Now that that review is out of the way, let's get on to the strategy of topping up to bracket. The bottom line of this strategy is this: Topping up to bracket means making an RRSP contribution in an amount that maximizes your tax rebate from that contribution, by limiting your contribution to the amount that would reduce your taxable income to the next lower tax bracket. That's a mouthful so we will break it down with an example.
You have a well-paying job and make a very comfortable income of $108,000 per year. You figure that eventually you will leave this job and retire, and that once you retire your income will be less. Because of this, you rightly figure that it's a good idea to make an RRSP contribution this year. You look at your 2020 Notice of Assessment, and you see that your accumulated RRSP contribution room is $52,000 because you haven't been using your whole RRSP contribution room every year. How do you decide how much to contribute? Here's how:
- Determine your tax bracket. In our last article I used the web site EY.com to find the tax brackets because I like the format of their tax rate tables and calculators. Look at the province you are living in, and click on the Tax Rate table for that province on the right side of the web site.
- In this example I will use British Columbia's tax rates. At an income of $108,000 you can see that your current marginal tax rate (rate on excess) is 38.29%. This is a combination of federal and provincial taxes.
- This marginal tax rate applies to incomes of $98,041 to $117,623. This is your tax bracket.
- Look at the next two lower tax rates. The next lower tax bracket ($96,867 to $98,040) has a marginal tax rate of 32.79%. This is lower than your current marginal tax rate by 5.5%.
- Calculate the difference between your income level, and the top of the previous tax bracket. In our example, we subtract $98,040 (the top of the previous tax bracket) from our earned income of $108,000. This equals $9,960. This is the amount of RRSP contribution room from which you will get the most efficient tax refund.
So we've determined that we will get the highest proportional tax refund from an RRSP contribution of $9,960. At your current marginal tax rate of 38.29%, by making this contribution you will reduce your tax payable by:
This is a big amount of savings that can grow your wealth if you invest and start earning an income (or growth) from it.
So there you have it, you've topped up your RRSP to bring your income down to the next lower tax bracket, saving the most tax per dollar of contribution as possible.
You could stop right here and what you've done would be "optimum" dollar per dollar. But what if you wanted to use more of that contribution room that you have? After all, you only used $9,960 of $52,000. Also, you know that when you retire you're going to be in a low tax bracket, so you figure you can still come out ahead.
Well, the more money you contribute, the less of a tax break per dollar you will have, but it may still be worth it. If you expect, for example, that your post-retirement taxable income will be in the range of $35,000, you know you can contribute much more now to get your tax break, and then when you withdraw it later in life you will be drawing it at a lower tax rate.
In our example above, the marginal tax rate at an income of $35,000 is 20.06%. So, If you withdraw money from your RRSP once you retire, you will only have to pay 20.06% of income tax on the withdrawal. See how the spread, from 38.29% on your contribution, to 20.06% on your withdrawal will save you over 18% of income tax?
It starts to get more complicated and speculative the further we take this example so I'm going to stop it here. A good financial planner would be able to run these scenarios for you if you don't want to do the math yourself….but most people don't have good financial planners….they have mutual fund sales people. See "Investment Advice. Who Can You Trust". Most bank "financial advisors" will simply advise you to contribute as much as you can. Their motivation is their own pocket book for sales incentives and trailing commissions. Now you know better and can hopefully spot someone who is not acting in your best interest.
By the way, if you're at the point of withdrawing from your RRSP….you can withdraw to bracket the same way, but in reverse. Just look to the next HIGHER tax bracket, and only withdraw as much as will bring your total income to that bracket, to ensure you are paying LESS tax dollar-for-dollar on your withdrawal.
What do you think? Have you done this before? If you've made RRSP contributions in the past, have you had financial advisors who laid this out for you, or did they just try to get you to put as much money as you could into your RRSPs? Let us know in the comments!
Happy tax season!
Links in this article:
EY.com tax calculators: https://www.ey.com/en_ca/tax/tax-calculators
British Columbia personal tax rate table: https://assets.ey.com/content/dam/ey-sites/ey-com/en_ca/topics/tax/tax-calculators/2021/ey-tax-rates-british-columbia-2021-06-15-v1.pdf
How to Understand Marginal Tax Rates: https://onfilandtime.com/20211030/how-to-understand-marginal-tax-rates-will-you-keep-less-money-if-you-get-a-pay-raise-into-the-next-tax-bracket
Investment Advice: Who can you trust? https://onfilandtime.com/20211016/investment-advice-who-can-you-trust