RRSP deadline: Can’t decide if you should contribute? Try the ‘see-saw method’

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March 1 is the deadline to contribute to your registered retirement savings plan for the 2021 tax year. If you’re still on the fence about whether you should put money into an RRSP, the “see-saw method” can help you decide.

“See-saw” is the analogy Ted Rechtshaffen, president and chief executive officer of TriDelta Financial in Toronto, uses to help clients understand one of the main differences between the RRSP and the tax-free savings account (TFSA).

With both the TFSA and the RRSP, investments held inside the accounts are tax-free.

“In that way they’re equal,” Mr. Rechtshaffen said.

The big difference is that with an RRSP your contributions are tax-deductible and your withdrawals are taxable. The deduction on contributions lowers your taxable income in a given year and can result in a smaller tax bill or a tax refund. But you’ll likely pay tax when you take money out.

Why 2022 is a year to dig deep for contributions to RRSPs and TFSAs

That’s where the see-saw comes in. The RRSP math works in your favour if you’re in a higher tax bracket when you’re claiming your deductions than when you’re taking out funds, Mr. Rechtshaffen noted. This is one of the main reasons RRSPs are such good retirement savings vehicles: Contributions are made when a person is working and likely to have a higher income than when they retire.

For example, imagine that, based on your income, you get a 40-per-cent tax break on your contribution, meaning that for every dollar you put in, you lower your tax bill by 40 cents. Now suppose you’ll have a lower income in retirement so that you’ll be taxed at 25 per cent. For every dollar you take out, you’ll pay just 25 cents in tax.

With a TFSA, on the other hand, there is no tax break on money coming in but also no tax on funds going out. Put another way – there is no see-saw. Your tax bracket when you make contributions and withdrawals doesn’t matter.

There may not be much of an advantage tax-wise to using an RRSP if your income remains roughly the same before and after retirement, according to David Field, founder of Papyrus Planning.

While most people see an income reduction in retirement, the size of that reduction matters, he said. If you’re just going from, say, a tax rate of 29 per cent to a tax rate of 24 per cent, the case for saving in an RRSP may be less compelling, he said.

The RRSP also has another potential drawback for lower earners: Withdrawals show up as income on your tax return. In retirement this could affect your eligibility for government benefits such as the Guaranteed Income Supplement or Old Age Security. Withdrawals from a TFSA, in contrast, have no impact.

If you can’t picture how your income levels before and after retirement will compare, it can be helpful to get a financial planner to draw up some scenarios, Mr. Rechtshaffen said.

As a general rule, he recommends that clients who make less than $45,000 a year save in a TFSA first and those who make more than $85,000 prioritize the RRSP.

Also, if you aren’t in a higher tax bracket now but expect your earnings to grow substantially in the future you may want to consider saving in a TFSA for now and then switching over to an RRSP once your income gets a boost, he added.

Once you’re in a higher tax bracket, you could even transfer some or all of the TFSA savings to the RRSP in order to generate a large tax deduction, Mr. Field said. Another option is to make RRSP contributions but hold off on claiming the tax deduction until you’re in a higher tax bracket, he added.

Another factor that will affect your tax see-saw is whether you’ll be able to take advantage of income splitting, which allows you to share eligible pension income with your spouse or common-law partner if you’re both at least 65 years old. Income splitting can significantly reduce your tax rate, tilting the see-saw downward.

Keep in mind, though, that a significant age difference between you and your partner or between when each of you retires will hamper your ability to take advantage of income splitting, he added.

Also, your RRSP see-saw could end up tilting upward, Mr. Rechtshaffen noted. Suppose you became a renter after selling your home for $2-million, which isn’t far-fetched these days if you live in a big city. If you had to put the money in an investment account that isn’t tax-sheltered, an annual growth of 5 per cent would result in a return of $100,000 just in the first year, which would likely propel you to a much higher tax bracket.

In general, optimizing your RRSP strategy may involve many considerations, which is what often makes the simplicity of the TFSA appealing to savers, Mr. Field said.

“You can’t really go wrong with the TFSA,” he said. “But just because the TFSA exists doesn’t mean the RRSP isn’t still a powerful solution for people to save.”

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