I think if the RRSP was named the Tax-Deferred Savings Plan it would clarify to folks how it all works. Most folks simply think of it as a Tax Avoidance program, but like death, there is no hiding from taxes.
The government rarely wants you to get something Tax Free (with the exception of the Tax Free Savings Account (TFSA), and a few other programs). When you get a refund for your RRSP deposit, all you are doing is deferring paying tax on your deposit. You will pay tax on the money in your RRSP when you withdraw it. This is why I am calling it the Tax Deferral Savings Plan. Remember there are tax deferral advantages possible, but you must realize that is what the RRSP does.
Some of the underlying assumptions for your RRSP are simple. When you withdraw money from your RRSP you will:
- Be in the same or lower tax bracket, thus your tax deferral is a net positive (if you have kept your refund from when you deposited into your RRSP).
- You have money saved to pay the taxes on the withdrawal.
This is where folks tend to get tripped up. They look at their RRSP balance and see the entire value ($X) , when in fact the actual value is ($X – Income Tax). How much income tax? Depends on when you take the money out, and how much you withdraw. Take it all out at once and you pay the most tax on that withdrawal.
Assuming you are making less when you are retired you are withdrawing at a lower tax rate (hopefully). If you have a higher tax rate when you are retired, you will pay more in tax than you got as a refund.
A dangerous idea is using your RRSP as an emergency fund. While it might work if you are unemployed (and have no income), using it to pay for a large purchase might give you a much bigger tax bill.
What to do with Refund?
If you put money into your RRSP (or tax-deferred savings plan) and you receive a refund, what should you do with it?
- If you spend the refund, you need a plan to recover it in some fashion. You must be able to pay the taxes on your deposit.
- Keep in mind the actual value of your RRSP deposit
- $X deposit gives $N refund, thus you will need approximately $N in tax payment money to withdraw all of $X again.
- Put the refund into the RRSP, problem solved, and you get another refund next year (repeat).
- Refund into TFSA, let it grow there, thus you have the Tax Money. An added bonus is you are using it to grow you nest egg (tax free).
- Hope your RRSP investments grow enough to cover $N worth of taxes due on the initial deposit.
Your RRSP Balance is Before Tax Money
Remember this, you must pay tax on your RRSP withdrawal (with a few exceptions), plan accordingly!