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The ideal tax advantage in reinvesting an RRSP refund comes when an individual is in a higher marginal tax rate.

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Getting a tax refund from a registered retirement savings plan (RRSP) contribution has become a rite of spring for many winter-weary Canadians.

But Jordan Damiani, senior wealth advisor at Meridian Credit Union in St. Catharines, Ont., says much of the lifelong tax-saving power of RRSPs is lost if the refunds aren’t reinvested.

“It’s not money you should use for a vacation or buying a big-screen TV,” he says.

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Using a basic compound interest calculator, Mr. Damiani contrasts the following three scenarios, each assuming an individual makes annual RRSP contributions of $5,000 for 35 years, beginning at the age of 30 and ending at retirement age of 65. He also assumes a modest annual return of 5 per cent, compounded monthly, for a diversified portfolio of equities, fixed income and cash:

1. Pocket the refund

RRSP refunds vary depending on the contributor’s marginal tax bracket; the higher the tax bracket, the bigger the refund.

Still, anyone who contributes $5,000 annually to their RRSP for 35 years and pockets the refund would retire at 65 with $491,290 as returns on all contributions would be $311,290.

2. Reinvest the refund when the individual is in a low tax bracket

The lowest marginal tax rate in Ontario, for example, is 20.05 per cent. At that rate, a $5,000 RRSP contribution would generate a tax refund of $1,003 for a total annual contribution of $6,003.

Those extra annual contributions of $1,003 may seem small, but they would compound along with the original contributions. After 35 years, the contributor would retire with $584,092 as returns on the original contributions plus the refunds would be $368,987. That’s a total of $92,802 more than not reinvesting the refunds.

But there’s a drawback for both scenarios. All those RRSP contributions and the returns they would generate would be taxed fully when withdrawn in retirement. At best, the contributor can withdraw the funds in the lowest tax bracket at 20.05 per cent. At worst, the individual will pay a higher tax rate than the refund rate from the original contribution.

Mr. Damiani says the better tax advantage would probably come from putting the contributions toward a tax-free savings account (TFSA). While TFSA contributions are not tax deductible, those contributions and any gains they generate over time are not taxed when withdrawn.

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“In most cases, we would recommend that person contribute to a TFSA in lieu of an RRSP,” he says.

Mr. Damiani adds that people in a low tax bracket who still want to contribute to their RRSP should consider not claiming the deduction until they’re in a higher tax bracket.

“You can always make a contribution to an RRSP and defer deducting it to a future taxation year,” he says.

3. Reinvest the refund when the individual is in a higher tax bracket

The ideal tax advantage comes from reinvesting an RRSP refund at a higher marginal tax rate. Using 43.41 per cent as an example, the combined federal and provincial rate for someone in Ontario earning between $93,209 and $144,489 annually, a $5,000 contribution would generate a refund of $2,171, making the total annual contribution $7,171.

After 35 years, the contributor would retire at 65 with $692,160 as returns on the original contributions plus the refunds would be $436,175. That’s a total of $108,068 more than reinvesting the refunds at a lower marginal tax rate and $200,870 more than not reinvesting the refunds at all.

In addition, the contributor can potentially withdraw funds in retirement at the lowest marginal rate of 20.05 per cent if the value of the RRSP doesn’t grow too much.

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“If you’re contributing money to an RRSP, the primary benefit the government is giving you is only a tax deferral. If you’re a high-income earner, you could also have the ability to eliminate taxes,” Mr. Damiani says.

If there are concerns an RRSP will grow too much and put the contributor in a higher tax bracket in retirement, he suggests diverting contributions and tax refunds to a TFSA. Once the TFSA contribution limit is reached, money can be diverted to a non-registered account in which only half of the capital gains are taxed and a tax credit can potentially be applied to dividend payouts.

Lorn Kutner, tax consultant at Northwood Family Office in Toronto, says another often overlooked tax strategy involves income splitting. As a general rule, higher-income spouses can split up to 50 per cent of their pension income with lower-income spouses who are in a lower tax bracket. But that income splitting is not permitted until the age of 65.

“If you’re under 65, it’s limited to certain life annuity payments and amounts received from the death of a spouse,” he says.

In cases in which taxable income varies between spouses who plan to retire or semi-retire before 65, he says the higher-income spouse should contribute to a spousal RRSP in which the higher-income spouse contributes to the lower-income spouse’s RRSP but is permitted to deduct the contribution in the higher tax bracket.

Still, Mr. Kutner says utilizing a spousal RRSP requires planning years before retirement.

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“You have to plan a bit to understand each of the spouse’s anticipated income levels in retirement,” he says. “If the lower-income spouse is anticipated to be the lower-income spouse for the foreseeable future and in retirement, it makes sense to make the contribution to the spousal RRSP.”

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