Four strategies to boost your RRSP savings
Canada Life - Jan 06, 2023
RRSP season is fast approaching. Here are four strategies to maximize your RRSP contributions
What is an RRSP used for?
You can use a registered retirement savings plan (RRSP) to:
- Save for retirement
- Split retirement income with your spouse with a spousal RRSP
- Help decrease the taxes you have to pay every year
Let’s look at how RRSPs work
RRSPs are a tax-deferred account you contribute to based on your prior year’s earned income – up to 2021’s yearly maximum of $27,830. Earned income includes employment and self-employment earnings plus any other income, minus employment expenses and business or rental losses from the previous year.
You can carry forward contribution amounts indefinitely if not used or deducted in any taxation year. A tax deduction becomes available in the year you make a contribution. You can use it to reduce taxes payable on your personal income tax return in that or a future year. You can contribute into an RRSP any time during the year, including the first 60 days of the year following the tax year.
All investment growth and income earned within the RRSP is tax-free until you take the money out of the account. When removed, the amount is fully taxable at your marginal tax rate (the amount of tax paid on an additional dollar of income). This can be very powerful when your marginal tax rate is high in the years when you’re making contributions and lower in the years when you take out money from the RRSP account.
Four strategies to contribute to an RRSP
1. Lump-sum deposit strategy
This straightforward strategy involves any after-tax money you wish to contribute into your RRSP. You’ll get a tax deduction in the year you contributed into your RRSP.
|Initial RRSP contribution||$5,000|
|Tax refund based on marginal tax rate of 40%1||$2,000|
|Total RRSP contribution||$5,000|
2. Reinvestment strategy
This strategy is like the previous one but includes an additional contribution from the tax refund generated by the original RRSP contribution. Once you receive your tax refund based on your lump-sum deposit, you can contribute that amount into your RRSP account. This will also provide an additional tax deduction in the following year.
|Initial RRSP contribution||$5,000|
|Tax refund based on marginal tax rate of 40%1||$7,000|
|Total RRSP contribution||$7,000|
3. Catch-up loan strategy
You can borrow money in the form of an RRSP loan to catch up on your available contribution room as specified on your notice of assessment. You may want to use the catch-up strategy if you’re having a particularly high-income earning year. You can use the tax refund to pay back the loan. Depending on the size of the loan, this can take up to a few months or years.
|Initial RRSP contribution||$5,000 (your investment) + $5,000 (loan) = $10,000|
|Tax refund based on marginal tax rate of 40%1||$4,000|
|Total RRSP contribution||$10,000|
4. Gross-up strategy
The gross-up strategy expands on the previous strategies. This is when you borrow an amount equal to the expected tax refund before making the contribution and use the actual tax refund to repay the loan. To apply this strategy, you need to know how much you want to contribute, your marginal tax rate, and how much you expect your refund to be based on your RRSP contribution. You’ll also need access to an RRSP line of credit to borrow the expected refund amount so you can contribute the full amount into the RRSP.
You can use this formula to calculate how much to borrow:
(RRSP contribution amount x marginal tax rate) / (1 - marginal tax rate) = gross-up amount to borrow
|Expected tax refund: $5,000 x 40%1 |
|Gross-up amount to borrow: $2,000 / (1 - 40%1) |
|Total RRSP contribution: $5,000 + $3,333 |
|Initial RRSP contribution||$8,333|
|Total RRSP contribution||$8,333|
Important considerations when borrowing
There’s always a risk when using borrowed money to invest.
- Interest charges should be minimal, as the loan is expected to be outstanding for only a few months at the most.
- The interest when borrowing to invest in an RRSP isn’t deductible.
- You shouldn’t spend your tax refund. Instead, you should use it to pay off the loan to avoid more interest charges.
Did you apply any RRSP contributions (or repayments) to the Home Buyers’ Plan or the Lifelong Learning Plan? They’re considered separately from the above strategies. These repayment amounts are not considered RRSP contributions for purposes of generating a tax refund.
With proper planning, you can strategize your RRSP contributions in a number of ways. If you’re a new investor, you may feel more comfortable starting with a lump-sum contribution. If you’re more experienced at investing, you may be more interested in exploring the gross-up strategy, which includes contributing your expected tax refund up front. Whether you’re trying to maximize your RRSP contribution each year, make catch-up contributions or take advantage of excess RRSP contribution room, you have the choice to choose the strategy that works for you.
I am here to support you and help you find the right RRSP savings strategy for you.
1. Assumed for illustrative purposes. To determine specific marginal tax rate, see following website: Government of Canada. (Jan. 2021). Canadian income tax rates for individuals – current and previous years. https://www.canada.ca/en/revenue-agency/services/tax/individuals/frequently-asked-questions-individuals/canadian-income-tax-rates-individuals-current-previous-years.html