Using RRSP Contribution Room to Avoid Taxes

by Mr. Cheap

In a comment on a recent post, AS requested information about an RRSP strategy I alluded to.  In the title, please note that I refer to AVOIDING taxes (which is legal and encouraged), not EVADING taxes (which is illegal and can get you sent to jail).  Please also note that I’m not an accountant or tax specialist, and although I’m fairly sure this is ok to do, I could be wrong (my numbers below are particularly suspect).  If anyone knows more than I do, please post any clarifications in the comments.  Also, I’ll acknowledge up front that there would be a fairly limited number of people who would be in a position to benefit from this.  Finally, Derek Foster presents a very similar strategy in his new book, so check that out if you’re intrigued by this and would like to read another take on it.  Tim Cestnick, Where Does All My Money Go? (Preet is Mr. RRSP), and  Efficient Market Canada each have more information about this idea.

We’ll all, at some point, probably be in the situation where our income will drop substantially compared to the year before.  Usually this happens when you retire (since you move from a higher working income to a lower pension), but can also happen if you get laid off (not as much fun), become a stay-at-home parent or go back to school (this happened to me).  If you know this is going to happen ahead of time, it becomes tempting to try to figure out a way to move some of your income forward, since you may be in a lower tax bracket in the second year.  Unused RRSP contribution room lets you do exactly this.

Say an Ontario man was earning $100,000 / year and was planning to head back to school.  While at school, he expects to continuing working part time and will earn $40,000.  Say he has $20K unused contribution room in his RRSP.  Using the 2009/10 tax rates, he’ll be going from a 43.41% to a 24.15% marginal tax rate.  Say on March 1st, 2010 (the RRSP contribution deadline for the 2009 tax year) he contributes the full $20k that he has in contribution room to a RRSP savings account.  This will save him (give a refund) of:

0.4341*(100,000 – 81,941) + 0.3941(81,941 – 80,000) = $8,604.36

After his taxes are submitted, he can then withdraw this money from his RRSP, at which point he’ll pay a withholding tax (like when the government withholds part of your paycheck).  HOWEVER, the withdrawal will actually be taxed as income in the year he withdrew it 2010 (he’ll get some of the withdrawal tax back when he reports it on line 129).  If his other income is $40k, he’ll incur a tax penalty of:

0.3115 * (60,000-40,726) + 0.2415 * (40,726-40,000) = $6,179.18

Therefore, overall he’s netted a tax savings of $2,425.18.  If his income in the first “high income” year was higher, or if his income in the second “low income” year was lower the benefit would be even greater.

There is a cost to doing this.  In this example, $20K of his RRSP contribution room is gone forever (you don’t get this back when you make an early withdrawal).  Derek Foster doesn’t like RRSPs and I’ve never been consistently in a high enough tax bracket to really benefit from them, so for us this isn’t that big of a deal.  HOWEVER, for most people lowering your income every year and allowing the funds within the RRSP to compound faster through tax-free growth is VERY worthwhile.  Burning $20k of contribution room to save $2.5k in taxes is of questionable benefit.

Obviously if the person in question were actually going back to school (or using the withdrawl to buy a house) there are programs like the home buyers plan and the lifelong learners plan.  To keep things (relatively) simple, I’ve ignored these.

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{ 13 comments… read them below or add one }

1 as

Thanks. What I was thinking is a bit wilder!?

In a situation where there is an existing large room for RRSP contributions and retirement is coming the following year (so that RRSP room has no real chance of ever being filled in the future), how about taking advantage of the two months at the beginning of the year (January and February) of overlap — where RRSP contributions are receiving the large tax refund (last income-rich year’s) and RRSP withdrawals are taxed at the lower tax rate (this retired-poor year’s)?

Withdraw large X and immediately contribute large X back. Claim big tax refund for last year, small tax to pay this year. Is this tax evading?

2 Traciatim

I told some friends about a similar strategy when we were talking about people with variable income jobs (Fisherman were what we were discussing) where some years are fantastic and some are scraping the bottom of the barrel. I suggested they should simply open an RRSP and average their last 5 years income, if they make more than this move money and in use something safe like a 1 year GIC or some other low cost item (or PC Financial worlds best RRSP; it’s just a savings account) and then in the slow years move money back out of the RRSP to have a much more predictable budget.

They told me I was crazy, and it was far too complicated. I’m thinking it’s as simple as using a savings account. I wonder why more people don’t do things like this. I guess that would take far too much personal responsibility.

3 Four Pillars

I did this one time in University when I had one year that had high income. I doubt it was worth the trouble since my “high” income year wasn’t all that high (but I had to pay taxes).

I don’t see why any of these suggestions would be illegal. What “AS” is suggesting is following the rules as well.

4 Mr. Cheap

as: I see what you’re saying: you actually withdraw the funds then contribute them back. I’m not sure if there are any restrictions on dates or whatnot, but I *THINK* that’s legit (maybe Preet will drop by and offer his opinion). The math would work out the same (you just wouldn’t need the $20k to put in for a little while). A third alternative is to do what I wrote about in the post and borrow the funds you contribute (then repay the loan when you get the refund and withdraw the funds)

Traciatim: Some people are really worried doing anything unusual (I think they worry that there are rules that will bite them or something). If it seems overly complicated to someone, they should pay an accountant, run the idea past him, and find out if there are any “gotchas”.

The one big downside (which doesn’t seem like it was your friends’ complaint), is that you’re losing your RRSP contribution room in order to smooth out your income (a better idea might just be to put away any income that’s “above average” for retirement, and live off of your low-income years’ income).

5 Jess

No mention about RRSP Loan? It’s better return!

A person who put $100 a month versus a person who took the loan to max their RRSP for $100 per month. Who has the better return?

You make those RRSP loan interest tax deductible and then you convert those RRSP in to a mutual fund i.e. “TD monthly Income” or some other fund. You have 3X return versus the traditional way of putting your money away.

BTW. If you withdrew RRSP with less than $5,000 you are taxed 10% only. More than $5,000 you’ll get taxed at 20%!

6 Traciatim

Jess, I don’t believe interest on a loan used to fund an RRSP is deductible.

http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/ncm-tx/rtrn/cmpltng/ddctns/lns206-236/221/fq-221-eng.html#a

7 Traciatim

Also Jess, those are the withholding rates which help you not have a huge tax bill the following year when making withdrawals (kind of like the withholding on a paycheck). You are taxed at your marginal rates on RRSP withdrawals.

http://www.cra-arc.gc.ca/tx/rgstrd/rrsprrif-reerferr/wthhldng-eng.html

8 Mr. Cheap

Jess: Actually, the withholding goes all the way up to 30% (http://www.wheredoesallmymoneygo.com/rrsp-withdrawals-are-subject-to-withholding-taxes/ ). This 10, 20 or 30% isn’t the actual tax you pay (it’s remitted on your behalf to CRA like paycheck deductions). The taxes you pay will be based on your marginal tax rate in the year of withdrawal. As Traciatim points out, you can’t deduct interest on an RRSP loan.

9 Mr. Cheap

Traciatim: Sorry for repeating your point, I started to respond before you’d written your second comment then got distracted (should have refreshed before posting my comment :-) ).

10 Jess

Sorry, I wasn’t clear. Yes, Interest on a loan for your RRSP is not tax deductible. However, money borrowed to earn non-registered investment income may be deductible. This is why it may make sense to use extra cash to contribute to your RRSP and borrowed funds for non-registered investments.

11 Jess

Thanks Mr Cheap & Traciatim for clarification! =)

12 WestcoastFP

Dude, you always, gotta be, like…. surfing the brackets, dude! (Me, trying to talk like a surfer.) Money – liquid, is worth more than money locked in and registered. So always consider taking out registered funds up until the point you reach the next tax bracket. Especially, prior to retirement.
This is a great example of someone working the tax brackets to their legal advantage.
Narly, dude!

13 Mr. Cheap

WestcoastFP: I *DO* like the brackets.

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