Christmas and other holiday festivities are a happy memory. New Year's Eve celebrations are history. Now, as we hunker down to survive another cold Canadian winter, the financial industry's annual retirement-savings campaign begins. Yes, RRSP season is here. Your financial advisor's call soliciting an RRSP contribution can't be far away.
RRSPs are promoted as a great way to save for retirement: Build a nest-egg to finance your post-work life and score a tax refund (RRSP contributions are tax deductible). At first blush, adding to your RRSP sounds like a slam-dunk. However, depending on personal circumstances, it may not be the best place for your hard-earned cash.
Answering these eight questions will help you decide whether an RRSP contribution makes sense this year.
1. Do you have an emergency fund?
How would you pay the bills if you lost your job? If you don't have an emergency fund, a pool of readily available cash to cover such unexpected expenses, allocating money for this purpose should take precedence over an RRSP contribution.
2. Do you have outstanding debt?
If you have high-interest debt such as an outstanding credit-card balance racking up debt at an interest rate of 20% or more, eliminating such debt is a better use of available cash than an RRSP contribution.
It might even make sense to pay down less expensive debt such as a line of credit or a car loan. Use the Investor Education Fund's Pay down debt or invest calculator to compute the break-even return rate for your RRSP contribution that matches the return from paying down debt.
3. Should you pay down your mortgage instead?
The classic quandary for many Canadians is whether it is better to pay down their mortgage or contribute to an RRSP. With mortgage rates near multi-year lows, an RRSP contribution is likely the best bet. For instance, based on a 3.5% mortgage rate and 35% marginal tax rate, the aforementioned calculator reports that your RRSP needs to earn just 3.56% before tax to match the return of paying down your mortgage.
To cover both bases, you could make an RRSP contribution and then use the tax refund to pay down your mortgage.
4. How big will your tax refund be?
The tax refund from an RRSP contribution varies considerably depending on your marginal tax bracket. For example, an RRSP contribution of $3,000 would yield a $602 break for an Ontario resident with $35,000 in taxable income (20.05% marginal rate) and a $1,300 tax break if her taxable income was $90,000 (43.41% marginal rate).
Depending on the anticipated refund, an RRSP contribution may or may not be the best use of your finite savings dollars. Use Morningstar's RRSP calculator to see what refund you can expect based on your province, your earned income and the contribution you plan to make.
5. How does your current taxable income compare to your anticipated future income?
If you expect your income to be significantly higher in the next few years, you may want to wait before contributing. RRSP room can be carried forward indefinitely, so you can save your contribution for a year when your tax rate is much higher and thus can result in a higher tax deduction, as explained in the previous point. This is especially relevant for young people at the start of their careers.
6. Have you contributed to a TFSA?
A relatively new quandary for taxpayers is whether to contribute to a tax-free savings account (TFSA) or to an RRSP.
A TFSA entails after-tax contributions and avoids tax on any profits made inside the account. Withdrawals and re-contributions are permitted. An RRSP defers tax on contributions and profit. Any money withdrawn is taxable as income and cannot be re-contributed.
Making a TFSA contribution (the annual limit is $5,500) and allocating remaining savings dollars to an RRSP allows you to save for retirement and access some savings without penalty, if required.
There are online tools such as the calculator at retirementadvisor.ca that compare the potential savings of an RRSP vs. a TFSA contribution based on personal details such as your age, income, marginal tax rate and years to retirement.
7. Does your employer match your RRSP contributions?
A matching RRSP contribution from your employer is essentially free money. An RRSP contribution that attracts the maximum employer matching amount is a generally a prudent retirement savings strategy.
8. What is your estimated retirement income?
An RRSP defers tax on contributions and profit. Any money taken out is taxable as income in the year of withdrawal. As a rule of thumb, an RRSP contribution makes sense if your income is likely to be lower when the funds are withdrawn at retirement.
However, if your estimated net retirement income (pensions, RRSP/RRIF withdrawals, investment income etc.) is already near the threshold for clawback of the Old Age Security (OAS) pension (currently $70,954), an RRSP contribution may not yield the tax savings you expect.
Adding more money to your RRSP now could result in future mandatory RRIF withdrawals that move your retirement income up into OAS clawback territory. Every dollar of income above that threshold will reduce your OAS by 15 cents.
If you are near retirement with little or no savings or pension, an RRSP contribution could reduce your income-tested government retirement benefits and credits. The income from RRSP or registered retirement income fund (RRIF) withdrawals could boost your retirement income above the levels that qualify for these government programs.