If the RRSP were named the Tax-Deferred Savings Plan, it would clarify how it works. Most folks think of it as a Tax Avoidance program, but there is no hiding from taxes like death.
The government rarely wants you to get something Tax Free (except for the Tax Free Savings Account (TFSA) and a few other programs). When you get a refund for your RRSP deposit, you only defer paying tax on your deposit. When you withdraw, you will pay tax on the money in your RRSP. This is why I am calling it the Tax Deferral Savings Plan. Remember that tax-deferred advantages are 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 depositing 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 ($X) when the actual value is ($X – Income Tax). How much income tax? It 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.
Retirement Withdrawal
Assuming you make 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 tax than you got as a refund. This is why most “Influencers” are down on the RRSP. They do seem to forget that a Spousal RRSP is an option.
Emergency Withdrawal
The idea is to use 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. If you are working with a Spousal RRSP this may work out better. This assumes your spouse is in a lower tax bracket.
What to do with the Refund?
If you put money into your RRSP (or tax-deferred savings plan) and 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. A 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!
It is possible to redeem some of your RRSP tax free. Take someone who retires early, has no work pension, defers CPP and OAS to age 70, and has a decent sized nest egg. By just using tax credits such as the basic amount, the age amount, the pension income amount, and medical expense amount, the person should be able to redeem as much as $20,000/year tax free.
Agreed, this can be done, but only by a Level 20 (or above) Accountant-Mage armed with a spell of true seeing and a quill of invincible arithmetic. There are ways around taxes, but please always be careful that the CRA agrees with your interpretations of their rules, and carefully check your arithmetic.
I have known this for a long time. When I tell people they tend to look at me like I’m from Mars.
What I do is insert a line in my balance sheet “Provision for future taxes. I calculate the amount by using my current tax rate. The criticism I get for this method is that I don’t know what my future tax rate will be. I think my method is probably more accurate than pulling a number out of thin air. So I use it.
By the way, I apply the same method to unrealized capital gains. This can be a real eye opener to people who have been accumulating capital gains for 20 to 40 years.
I like this methodology a lot. No, it is not rock solid accurate, but it is close enough that it gets across the point that the number you have is not correct.