Young Canadians who have maxed out their tax free savings account (TFSA) might wonder where they should put their savings next. The registered retirement savings plan (RRSP) is often the suggested next move – but when is the right time to start contributing and claiming the deductions?
An RRSP is a tax-deferral account, which generally operates under the assumption that investors will be in a higher tax bracket when they contribute than when they withdraw funds, triggering taxation. This means that deciding when to invest in an RRSP is particularly important when someone is at the beginning of their career and could expect rapid increases in their salary over the next few years.
After filling up their TFSAs and before investing in an RRSP, experts recommend maintaining an accessible emergency fund – which is particularly important now as some experts are predicting a recession in the next two years.
Before opening an RRSP, young Canadians might consider first filling up their Tax-Free First Home Savings Account, a new tool available starting next year. This account will allow up to an $8,000 contribution every year and on the fifteenth year, if not used to buy real estate, will be automatically transferred to an RRSP tax-free.
Investors who have decided to invest in their RRSP might not be aware that they are not required to claim the deduction against their income in the year they contribute. It’s possible to delay claiming for one, five or even ten years without penalty while the investment gains compounding interest within the RRSP.
But is delaying claiming the deduction always the best idea? Not according to experts.
Whether or not to claim the deduction in the year of contribution hinges on two factors: the time value of money if the deduction is claimed right away, and the higher tax deduction in the future if the deduction is delayed. Additionally, investors should be aware of the conditions of withdrawing funds from the account early if required.
According to Laurier University accounting professor Jonathan Farrar, delaying a claim is a good idea if an investor expects their income to jump substantially into the next tax bracket in the next five or ten years. In his experience, he said, very few people take advantage of this option, many because they don’t know it exists.
Imagine a young investor from Ontario makes $60,000 and invests $6,000 in their RRSP. If they claim that amount on their taxes this year, they will reduce their taxable income by the contribution amount and save $1,779 in taxes. They can then reinvest that amount and start accruing compounding interest right away.
If the investor delayed claiming the amount by a few years when their income is still within the same tax bracket, they will receive the same tax benefit of $1,779. However, if they wait until they are in the next tax bracket – over about $100,000 – that same $6,000 deduction will result in larger tax savings of $2,199. The savings are even more significant if their salary jumps to $150,000, at $2,605.
For people going into jobs with steep rises in pay in sectors like technology, medicine or law, this is not an unlikely scenario. But planning around uncertain future circumstances presents a risk: Prof. Farrar says the challenge is that “there’s no guarantee someone’s going to be in that job in five years.”
Moreover, salaries have generally not kept up with inflation. This issue has been exacerbated in 2022, with banks expecting the rate of inflation to average 7.2 per cent in 2022.
If rapid salary growth is unlikely, saving the deduction for later is not always ideal, according to Diana Orlic, a wealth advisor at Richardson Wealth Ltd. For those who expect their income to remain in the same tax bracket for the foreseeable future, it makes sense to claim the tax credit right away and invest the proceeds in a TFSA the following year.
While positive market performance is never guaranteed, Ms. Orlic said that, assuming a growth rate of five per cent, “it turns out that you’re still further ahead than you would be by saving your contributions.”
The other benefit to this approach is that the investor will then have access to more cash to contribute to another account, such as a registered education savings plan for children or a TFSA in the next year, said Sami Nathoo, senior financial planner at Raymond James Ltd.
The downside to RRSPs is that there are barriers to taking funds out, said Mr. Nathoo. While investors get their contribution room back the following year with a TFSA, no such space is added back to an RRSP the year after a withdrawal, meaning the tax-advantaged space is permanently lost.
As a result, Mr. Nathoo said, investors should understand the long-term implications of investing in their RRSPs in the first place.
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