The Perfect RRSP Strategy

EPISODE SUMMARY

Is it possible to have a perfect RRSP strategy?  Well it depends.... In this episode, I'm joined by my colleague, Jordan Arndt, and we discuss the situations where an RRSP can provide the most value to you as a long-term investor.

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TOPICS IN THIS EPISODE

1. RRSP contribution deadline 
2. RRSP definition and details 
3. Options with your RRSP refund 
4. Determining whether the perfect RRSP strategy exists 

RESOURCES MENTIONED

Government of Canada - RRSP Information

EY Tax Calculator and Rates


OTHER EPISODES

13. Is an RRSP the Best Choice for your Retirement Savings

25. Reduce Taxes with a Spousal RRSP 

29. RRSP, LIRA, TFSA…Where do you Withdraw From First?


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Transcript

Evan Neufeld: Hello, and welcome back to the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld.  Today we are getting close to the end of our second season and so I thought it'd be a good time to talk about the perfect RRSP strategy.  Now before we get started today, I'm actually going to be joined for this episode by one of my colleagues and fellow advisors here at Enns & Baxter Wealth Management. Please welcome Jordan Arndt to the show. 

Jordan Arndt: Thanks for having me. I'm excited to be here. 

Evan Neufeld: Thanks for joining me today, this is going to be fun. So I talked in the intro about the end of RRSP season. That might be a bit of an industry term here, but essentially, there is a deadline to make an RRSP contribution based on last year's income. So RRSPs are a little bit goofy that way. If you want to make a contribution to reduce your income from 2021, you still have the first 60 days of the year to do that. So for this year, that means March 1st is the last day that you can make an RRSP contribution for the 2021 tax year. So now in RRSP, let's remind everybody that is a registered retirement savings plan. Because it has retirement in the name, should everybody be using one of these to save for retirement Jordan. 

Jordan Arndt: You mentioned in the intro, there's a perfect RRSP strategy. So based on that, I'm going to say yes. However, I think it depends. 

Evan Neufeld: Yes, Like every good answer. My argument would be that no, not everybody should make one and there are a few situations that would be better than others to make the RRSP work in your favour. Now maybe we should do a little bit of a rundown of what an RRSP actually does in the mechanism for how it works. So Jordan, can you remind our audience here? What an RRSP actually is? 

Jordan Arndt: An RRSP is just another plan type that we can use to allow our money to grow for investment purposes and specifically retirement. It has special tax treatment and Evan, did you want to get into the details on that?

Evan Neufeld: Yeah. Sure. So essentially when you make an RRSP contribution, it reduces your income. So in most people's case, if you have employment income, that means you already paid tax on your money. So when you make an RRSP contribution, you're going to get a refund for your contribution there. So a lot of people say that an RRSP contribution is kind of like investing pre-tax money because you get their tax money back when you make the contribution.  Maybe I'm jumping ahead of myself here a little bit, but I'm going to get back to that in a second. I would make the argument that that's not actually the best understanding of how it works, but functionally speaking, it's just a plan type that you get a refund for making a contribution. But when you take your money out in retirement or any time you have to pay tax on every dollar as well.  If you want to learn a little bit more about RRSPs, I've had a few episodes where I've talked in more detail about how they all work and a few other situations here, but let's get into it right away with what is the best way to use an RRSP? Well, as we kind of alluded to, it depends on your situation.

Now, if you are like most Canadians that contribute to RRSPs, you have employment income. And before you get paid, your employer takes income tax off what you get paid and sends it to CRA on your behalf. What you get left with in your bank account is what we call after tax money. So if you are making a contribution to your RRSP with after tax money, that means you're going to get a refund.

But if the concept of the RRSP revolves around investing pre-tax money, that refund isn't a bonus. That's not free money that is designed to be reinvested so that your RRSP pool is bigger than what you would have originally been able to contribute out of your bank account on your own. So, the real question here is what do you do with your refund? So what are some options of what people can do with their RRSP? 

Jordan Arndt: Simply, I guess you could just go and spend it. We all have many ways we can find to spend a few extra shackles.

Evan Neufeld: Especially with inflation being as high as it is. 

Jordan Arndt: And actually with inflation you can reinvest your refund. You can put it down on debt. Perhaps you can give it to charity as well if you are charitably inclined or looking to give some money away. 

Evan Neufeld: Okay. So let's walk through a few of those options there. So spending the money Okay, I like spending money as much as the next person, but if we're looking towards long-term and this contribution is designed to be retirement income in the future, if you're spending your refund, you're essentially lighting that money on fire, because it is just turning into, I don't know, new car or vacation.  These things are all well and good, but if it's not meeting the goals, it's not working in your favor and it's going to be working against you. So what about re contributing or re-investing that refund in the RRSP? How does that mechanism actually work?

Jordan Arndt: Yeah, I think that's of course we're beyond spending and now we're looking at re-contributing our refund to continue the growth. So of course, taking that tax refund and putting it back in the RRSP is a great option to continue that tax deferral and save money and have it grow for our investment goals.  And maybe in this case specifically, retirement. What's interesting about that is if you get a refund, there's the behavior aspect of having to remember to invest that back into the RRSP and so there's nothing automatic there, you don't know exactly how much your refund is from your RRSP contribution.  And so, you know, I think we just need to be careful to make sure that we are contributing that money back into the RRSP.

Evan Neufeld: Right. So if you were to take your refund and put it back into the RRSP. Kind of the cool thing that happens there is that it'll generate another refund the next year. So there's almost kind of like a trickle-down effect here, refund on the refund.  So let's just use a hypothetical here so people can kind of wrap their head around it. So if they're in the 33% tax bracket again, go back and look at my episode about marginal tax rates to understand what we're talking about there. But if you're saying the 33% tax bracket and you make a thousand dollar RRSP contribution, you're going to get about $330 back.  So what do you do with that $330? Well, you could do another RRSP contribution. And Jordan, what's the math on that one.

Jordan Arndt: In that case you might get about $110 back the following year. 

Evan Neufeld: There we go. So if you reinvested the refund, then it can kind of create smaller refunds as it goes. The math gets a little bit complicated if you want to keep doing that down there, but that's essentially how that works.

So with the goal there being to have a much bigger RRSP pool to account for the future taxes, when you have to take the money out.  Use the same concept of reinvesting that refund, which I highly recommend. If that hasn't been abundantly clear already. But what if you take your RRSP refund and you invest that in the TFSA, what does that look?

Jordan Arndt: Yeah, that's an interesting alternative the TFSA. You will not get a future refund on that. However, that growth is entirely, as the name suggests, tax free. And so if you contribute back to the RRSP, the tax man is coming, at some point when you want to withdraw. In the case of the TFSA, it is also a savings plan or a place that we can put investment dollars.  However, there is no tax on that growth upon withdrawal, whenever that may be.

Evan Neufeld: So if you have room in your TFSA, this strategy is bordering on that perfect strategy because if we go back and look at what happens when you reinvest that money into the RRSP, you have a big pool of RRSP money, but the problem becomes the future tax bill associated with that.  Whether that's on spending when you retire or upon death, if you have to leave that to your beneficiaries. So the nice thing is if you're taking your refund and you're investing that in the TFSA, well that can create growth for you in a tax-free way today and tomorrow, and even after you pass away.  So you kind of get the best of both worlds by doing the RRSP contribution and then reinvesting the refund in your TFSA.

Jordan Arndt: I totally agree Evan.  It takes away some of the challenges as well with remembering to continue to, you know, the concept of the refund on the refund. Well, that turns into a third refund and a fourth refund but with the TFSA you re-contributed once into the TFSA and you don't have to worry about doing anything in future years.  Again, it's just a little bit simpler, a little bit cleaner and ultimately produces a very near similar result in the long run. 

Evan Neufeld: So those are some of the options for what to do with the refund on the investment side. But a lot of people say that they want to use it to pay down debt. Is that an advisable strategy in many cases?

Jordan Arndt: I definitely think there's some cases where using your refund to pay down debt certainly makes sense. A classic case or an obvious case would be something like a credit card. Maybe you're paying, you know, just under almost 20% interest on that. If you have credit card debt, there's not going to be many better uses of a refund or some extra cash to not pay that down.  It gets a little bit more complicated maybe as that interest rate on your debt gets lower or something like a mortgage rates have been fairly low recently, is that a better option compared to re-investing? It depends. I'm going to use the bad answer of it depends. The numbers would suggest not though. You know, in terms of maximizing, I guess the dollar benefit to you, the answer would be no. If you have low debt, like something like a mortgage given historical rates here recently investing that into a TFSA like we've talked is probably a better option. That's going to produce a larger value for you in the long run.

Evan Neufeld: Right. And the key thing there you mentioned is the long run. So if we're looking at someone with a longer time horizon investing, there's no guarantees when it comes to investing of course, but even if you use a pretty conservative rate of return on an investment, chances are over a 10 to 20 year time horizon investing should outperform But if you've maxed out your TFSA, say for example, your home is also a tax-free asset that is hopefully growing here in Saskatchewan. Our rates of real estate growth are a lot less than places like Vancouver and Toronto, right?

That's also a tax-free asset to you. So that's accumulating in that way. So paying down some of your mortgage debt, it's not necessarily a bad idea though, either, especially if you're getting close to retirement in that timeline is a lot shorter for sure. 

Jordan Arndt: That's a great point. 

Evan Neufeld: Okay. So let's put together a bit of a hypothetical scenario here.  So what is the best way to use an RRSP for someone who's earning income in what I would call the middle tax bracket. So here in Saskatchewan, most provinces are pretty similar, but here in Saskatchewan, it's pretty close to between 50,000 and 100,000 that marginal tax rate is about 33%.  So a lot of people find themselves in that middle bracket, early career, later career. Average or even a little bit above average, actually. So say someone that's earning $75,000 here in Saskatchewan, how do we best use an RRSP to our advantage. 

Jordan Arndt: I think of course the challenge is predicting what your tax rate will be like in retirement.  We can only do the best that we can with our assumptions, but in the case where you're a mid-bracket earner, an RRSP is a reasonable strategy. But perhaps a more beneficial strategy would be to just take your after-tax dollars and contribute them directly into a TFSA.

Evan Neufeld: Hold on, hold on. The best RRSP strategy is actually using the TFSA.

Jordan Arndt: The perfect strategy is maybe not use it at all. Of course, again, like I said, it depends on some assumptions and projecting tax rates into the future and in retirement, which can be challenging. However, investing in the TFSA removes some of the concerns or needs to have to reinvest it in the future.  So yeah, investing a hundred percent in TFSA seems to be the best option if you are in that middle bracket.

Evan Neufeld: This is where the personal finance component comes into it. Like if we're just looking at numbers on a page, it says, well if we're in the same bracket when we contribute and the same bracket when we withdraw, it should be functionally exactly the same, the RRSP versus the TFSA, but let's remember how the RRSP works.  So if you have employment income, you've got money in your bank account, you make your RSP contribution. You file your taxes and you wait to get your refund. Then you have to have the discipline to reinvest the refund and in many cases, that whole song and dance just equals the benefit of the TFSA when you could have just put it in there the whole time.

And if you actually look at the leg time between when you make your contribution, when you get your refund and when you actually reinvest it, that might be enough time where the TFSA actually does make it better because your money was invested for you that whole time. So someone in the middle bracket, there is a case to be made, but the discipline, the personal discipline to do everything right and predict your future tax rate is it takes a little bit more legwork. So is an RRSP wrong for someone there? I would say not. And again, we're just talking personal RRSP here.  If you have something at work that is a lot easier to make it work because they are able to invest pre-tax money for you. 

Jordan Arndt: Absolutely and that that removes some of the behavioral piece like you're talking about and the personal considerations. 

Evan Neufeld: And especially if your employer does any matching, boy the rate of return on free money is pretty high.  It would be tough to beat. So I would recommend that if you have a workplace plan, if you're self-employed, it's a little bit different again, but if you're just a regular employed person making anywhere between that 50,000 to a 100,000. It's tough to really make the argument to use an RRSP over a TFSA if you have the TFSA room.

Okay. So let's jump ahead then to someone who is what I would call a high income earner. So someone who would be in those higher tax brackets, let's just go to the extremes and then you can extrapolate from there where you might fit. So someone in the highest tax bracket in Saskatchewan. You have to pay 47 and a half percent there.  Let's just use a nice round number, like 250,000. So someone who's making 250,000 here in Saskatchewan, you're paying 47 and a half. Some provinces it's more than that, some provinces is a little bit less, but the point will still remain. So if you're making a $10,000 contribution, making $250,000, the refund that you can expect there is about $4,750. That's pretty good. So in that case for someone who's earning $250,000 during their working years are most of those people still having incomes of 250,000 in retirement?

Jordan Arndt: Yeah. That's kind of the big question to answer, but of course, most likely not. That is a very high salary of course in today's dollars. And to be equally that in retirement is just unlikely given most people's situation in retirement savings. 

Evan Neufeld: If that means they have a lower income, that means that they're going to be paying a lower rate of tax.  Because again, our tax system is what we call progressive. So the more the more money you make, the more tax you pay. And so if you have a lower income in retirement, again, enough to drop an actual tax bracket, not just lower and stay in the same bracket, but if you're able to drop a tax. That's where it can really, really start to make a lot of sense, because the amount that you get from your refund is large enough and the differential between today's tax rate and the future tax rate is large enough to so  it becomes a lot more likely that the RRSP is going to work in your favor over the long term. 

Jordan Arndt: Totally agree. And this is an interesting scenario and as Evan, was mentioning, the more your differential between today's tax rate and future marginal tax rate, as that increases the benefit increases in the RRSP.

And in this case, I think there is almost, dare I say, perfect scenario that you can kind of paint out on paper. And in that case, that would be investing into an RRSP and continuing to reinvest the refunds into the RRSP every year. 

Evan Neufeld: Right. And the reason for that again, is because your tax rate differential is so large that the benefit is almost too hard to ignore.

Like when it's exactly the same, it's like, wow, we should have just used the TFSA. But now, almost a guarantee that your tax rate's going to be lower later. The differential there that's free money. 

Jordan Arndt: And back to the refund on refund, on refund concept. That refund continues to grow and allows you to provide more capital to invest, which then provides more growth and allows for a larger pool of retirement.

Evan Neufeld: Pretty cool. So the perfect RRSP strategy is different for a lot of people. But let's go through some of those scenarios again. So let's do it per person. So someone who is a mid-bracket earner, the perfect RRSP strategy is going to be tough to do. And so the perfect RRSP strategy for a mid-bracket earner is probably a TFSA.  And a low bracket earner, it would be the same thing. So anything under about 50,000, I would probably make the argument to just keep using your TFSA because there's this concept called Occam's razor, let's really get into French philosophy here. The idea there is that if you're comparing two scenarios that expect to have the same outcome.  You should choose the one that has the fewest assumptions. Obviously, it's imperfect a little bit. But behavior is a huge component to this. So mid bracket, low bracket, let's cut out all these assumptions. Let's cut out all the discipline. Let's cut out all the future predicting for your future tax rate.  Let's just use that TFSA.

Jordan Arndt: Ockham didn't know it he was ahead of his time, but he was touching on a TFSAs and RRSP. 

Evan Neufeld: absolutely. It was about a thousand years exactly. Okay, so let's do the audience some credit here, though say TFSA room has already maxed out. How do we best use the RRSP to our advantage then as a mid-bracket person.

Jordan Arndt: An RRSP is a great option in that case.  And it does allow for a preferential tax treatment today. Most likely the best scenario in that case would be invest your after-tax dollars in an RRSP today and when you receive that refund, come tax time next year, put that money back into a TFSA right away. Don't worry about trying to invest refunds over many years, but take that one refund invest it into a TFSA and use those dollars to grow.

Evan Neufeld: And the reason that you're able to do that is that the next calendar year you'll get more TFSA room. So yeah, assuming you've got the more room coming again in the following calendar year, that can be a decent way to do that. So then for the high-income earner, the RRSP, get your refund and then right back into the RRSP, let's not beat around the bush here.  Then the benefit of that high tax rate is it's going to work to your advantage more often than not. So anyone that's making above that minimum bracket. That's where it can really start to make sense when the RRSPs is really great. Another situational thing, so not based on how much money you're earning, but if you're making RRSP contribution and you plan to get a refund for it, if you have high interest debt like credit card debt, even some car loans that are seven to 10%, boy it is pretty tough to beat that have to beat that I have to beat.

So I would say. If you have debt in that 7% plus range, that's when you can say, okay, well let's make an RRSP contribution. Let's get a little bit of a refund and throw it against the debt. You're going to be in a much better financial situation currently and in the long-term as well.  Well hopefully that answers a few questions as it pertains to RRSPs.  Again, the deadline for 2022 is March 1st. So you can make a contribution between now and March 1st for the 2021 tax year. And if you find yourself in any of those situations where an RRSP makes the most sense, keep that in mind. But if you have the TFSA. I am a huge believer in the TFSA and you could do a lot worse than making a TFSA contribution as well.

Jordan Arndt: Can't go wrong with the TFSA. Seems to be a winner. 

Evan Neufeld: All right. Well, thanks a lot, Jordan, for joining me today and we'll see you again next time. 

Jordan Arndt: Thanks Evan, thanks for having me.

Evan Neufeld:  Thanks for joining me today on the Canadian Money Roadmap podcast. If you enjoyed today's episode, I'd really appreciate if you left me a review on apple podcasts with your biggest takeaway. If you have questions or ideas for topics you'd like me to discuss on future episodes, please reach out via my contact info in the show notes.  This podcast is intended to be educational in nature, and you should always consult your finance, tax and legal advisors before making changes to your financial plan. Any rates of return discussed are historical or hypothetical and are to be used for educational purposes only. Evan Neufeld is a Certified Financial Planner and registered investment fund advisor. Mutual funds are provided through Sterling Mutuals Inc.