Question from 30-year-old reader: “I was on the Canada Emergency Response Benefit in 2020 – all seven periods. I got rehired in December and I’m still working now. My total taxable income will be $50,000 in 2020 – lower than my normal $65,000, but CERB hasn’t been taxed yet. I have $5,000 in my emergency account and I’m debt free. Should I invest it in my registered retirement savings plan during this RRSP season? I only have $10,000 in my RRSPs and I’m worried about owing taxes on CERB. I’m hoping I can reduce my tax bill and use my RRSP for the Lifelong Learning Plan next year to help pay for full-time school to retrain in September, 2022.”
Answer from Shannon Lee Simmons, a financial planner and founder of The New School of Finance in Toronto: Hey there, okay, I see where you’re coming from but there are a few things to consider before taking advantage of RRSP season.
Let’s review. RRSP season is the first 60 days of the year. This year, Jan. 1 to March 1. Any money you contribute to an RRSP during this time can be used reduce last year’s income. For example, if you were an employee who made $50,000 a year (pre-tax) in 2020 between CERB and salary – let’ say $14,000 in CERB and $36,000 in salary. If your employer already took all the proper deductions, you’d owe approximately $3,391 at tax time. If you saved $5,000 to your RRSP during the first 60 days, you’d only pay income tax on $45,000, which is the $50,000 minus the $5,000. If you’re only paying tax on $45,000, you’d owe approximately $1,959. So, $5,000 saves you $1,432. These numbers were calculated using an online tax calculator. The taxes owing are on your income, including CERB. They also take deductions from your employer into account. These would be your taxes owing after employer deductions.
While saving tax is always fun, I see three red flags here.
Red Flag No. 1: Using your emergency account as an RRSP contribution.
You said that you would be using your entire emergency account for this RRSP contribution. If you use the entire $5,000, you’ll still owe $1,959 in taxes. I worry about how you will pay the remaining taxes owing. Often, this will go onto lines of credit because RRSP contributions do reduce taxes owing but they won’t reduce them dollar for dollar for you. In addition, using your entire emergency account during the pandemic could be a risky move if you lose your job or have another emergency in 2021. My usual advice is to use extra money to pay down consumer debt first, establish an emergency fund and then, and only then, use extra savings for RRSP and TFSA contributions.
Red Flag No. 2: Watch your time horizon and purpose of the money. Invested RRSP isn’t always best.
If your RRSP is invested, there’s volatility. No way around it, as soon as you leave high interest accounts and GICs, there’s volatility in the bond market and stock market. Just to confirm, products like exchange-traded funds (ETFs), index funds and mutual funds are all made up of securities like bonds and stocks. So, they have volatility too. Volatility isn’t an issue, in fact, it’s very normal. With money that is invested for the long-run, short-run fluctuations shouldn’t matter because you have time on your side. You can wait out any volatile periods so that you don’t have to take money out. But, you said that you intend to use the Lifelong Learning Plan to pay for full-time school in September, 2022. That’s a short time horizon. It would not be great if the markets took a downturn right when you wanted to pull money out to pay for tuition. My general rule of thumb is that money needed within 18 to 24 months should not be invested. That being said, anyone can still open an RRSP and not invest. An RRSP that is a high-interest RRSP, for example, would allow you to use the RRSP deduction and Lifelong Learning Plan, but not worry about investment risk.
Red Flag No. 3: Your income last year was lower than normal.
One of the best things about RRSP season is the fact that you can lower last year’s tax bill. Like going back in time to change the future. It’s awesome. However, because you were laid off last year and on CERB, your income of $50,000 was lower than normal. That means your tax rate was lower in 2020 than it will likely be if you continue to have full employment in 2021. The higher your income, the bigger the tax break from RRSP contributions. There may be an opportunity to wait on RRSP contributions, and use them against 2021 income rather than 2020 income, because you’ll get more tax money back given that you’re in a higher tax bracket in 2021 than 2020.
In short, in terms of contributing to an RRSP, I’d leave that $5,000 alone. Use a portion of it to pay your tax bill – $3,391 (the amount you owe on $50,000 including CERB), and use the remaining $1,609 ($5,000 minus $3,391) as emergency money, which means it will remain liquid, easily accessible and not invested. Lastly, any new savings should go to rebuilding your emergency account. Once that’s built back up, I’d put the extra money in a non-invested RRSP that is earmarked for school tuition in September, 2022.
Shannon Lee Simmons is a financial planner and founder of The New School of Finance in Toronto.
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