Rushing to make the RRSP deadline? Expecting the Guaranteed Income Supplement (GIS) in retirement? Then walk don’t run to your financial institution. Indeed, go there next week after the RRSP rush. Because you shouldn’t be making an RRSP contribution but more likely a withdrawal. And if you want to shelter some of your capital income from tax, use a tax-free savings account.
Here’s an example. Suppose you are 64 and are going to contribute $1,000 to a brand-new RRSP. You have a marginal tax rate of 30 per cent so this will give you a tax refund of 30 per cent of $1,000 or $300. You save the $300. You get interest of 3 per cent, so a year from now you will have $1,030 inside your RRSP. Your $300 outside the RRSP is now $309 (ignoring the couple of bucks you may have to pay in tax on that $9 interest).
Now suppose next year you retire and receive Old Age Security and Guaranteed Income Supplement (OAS/GIS). Suppose for some reason you withdraw that $1,000 contribution. That withdrawal will count as income for GIS purposes and it will be subject to the GIS phaseout. Say that phaseout is 50 per cent: In some circumstances it will be higher. Hence you will have 50 per cent left from your $1,030 or $515 plus the $309 from outside or $824. Your rate of return on your $1,000 would be minus 16 per cent. Not good.
But you say who is going to withdraw the $1,000 RRSP contribution the very next year? Won’t it turn out well if the contribution is just left in long enough so that the tax-free compounding takes effect within the RRSP? No, at the current low interest rates, you will likely die before the strategy would be as good as making the same saving without an RRSP, as I confirmed in a large number of calculations for a paper soon to be released by the Canadian Labour Market and Skills Researcher Network (CLSRN). The effect of the 50 per cent GIS phaseout is just too strong.
Here’s the kicker. If you are going to be a GIS recipient next year (and you are not already a recipient of a related transfer payment called the Allowance due to having an older spouse or being a widow/widower), it may be a good idea to withdraw any and all of your RRSP funds this year. (If your RRSP is large, I recommend obtaining some reputable tax advice.) You may pay a lot of tax on that withdrawal, but you will beat that 50 per cent GIS phaseout. And many GIS recipients also pay personal income tax on their RRSP withdrawals, as the data in my CLSRN paper shows.
There is nothing new here. Richard Shillington described the problem in papers for the C.D. Howe Institute in 1999 and 2003. Unfortunately the common message that RRSP contributions are good is geared for the affluent and not for those with lower incomes. But including the GIS phaseout, low-income seniors in Canada are subject to very high effective tax rates. It is wise to be aware of them.