As February draws to a close, so too does this year’s RRSP season (or SZN, like the kids say).
This means that your window to apply RRSP contributions against your 2021 income is closing.
In our last blog post, we discussed the basics of the RRSP.
Now, let’s take your RRSP knowledge to the next level by discussing five strategies that you can use to make the most out of your RRSP, both immediately and in the future.
Many Canadians wait until the end of RRSP season to make a lump-sum contribution. While there is the advantage of knowing your income (and likely tax burden) to assist in making the appropriate RRSP contribution, it might not be the ideal solution.
Instead, consider setting up a pre-authorized contribution (PAC) plan. This involves investing a fixed amount at regular intervals (usually monthly but could be weekly or bi-weekly).
This strategy works for several reasons.
No more scrambling to find the dough
First off, coming up with a lump sum to invest can be tricky. For example, you might have intended to invest $5,000 into your RRSP, but that quickly becomes $1,000 after holiday spending and that spontaneous vacation in December.
Instead of struggling to cobble together a lump sum to contribute in late February, consider breaking it up into more manageable chunks over the course of the year.
It reminds me of the wise words of Desmond Tutu:
Think of it this way: Is it easier to find $200/month or come up with $2400 in February?
A trick to help you with regular investing is to automate your savings.
Set them up so that your contributions come out on the 1st of the month (for example). That money automatically gets deposited into your RRSP, and you don’t have the opportunity to spend it.
You’ll probably find, after a few months, that you don’t “miss” the additional amount saved and that your spending has adjusted to fit the amount available.
By investing a fixed amount at regular intervals, you take advantage of a powerful concept called Dollar-cost averaging.
It takes advantage of fluctuating prices and, over time, can lower the average price per fund unit. This can potentially provide for a better end result for your portfolio.
Contrast this with a single lump-sum investment. By investing all at once, you put yourself at the mercy of the market.
What happens if the market happens to fall right after you make your contribution? While we advocate a long-term view, the psychological impact of seeing your investment go down immediately after purchase can’t be underestimated.
As an example, suppose you invested $1,000 a month from January-May into the ABC Fund.
The ABC fund values over those five months were $25, $20, $13.33, $16.67 and $25.
What do those monthly purchases look like after the May contribution?
Price per unit
# of units purchased
If you invested $5,000 in a lump sum on January 1, at a market price of $25/unit, you would have purchased 200 units.
By dollar-cost averaging, you end up with 265 units by May, even though the unit price is still the same as in January.
Invest the Return
So, you made an RRSP contribution, brought your taxable income down a bracket, and received a solid refund from your good friends at the Canada Revenue Agency (CRA).
Time to book that trip to Jamaica or cop those Concord 11s off of StockX, right?
Not so fast, my friend.
The refund you received wasn’t some crazy windfall. A refund occurs when the CRA collects more income tax than you were supposed to pay and then refunds the overpayment. As a result, they are returning YOUR money to you.
While the “Treat Yo Self” crowd might disagree, there is a better way to deploy these funds to work on getting ahead.
If you have credit card debt or outstanding loans, use these funds to pay down the balance.
Use the money to make an extra payment towards your mortgage.
Increase your monthly contributions (or make a lump sum investment) to your RRSP or TFSA.
Smartly utilizing the refund will ensure that your long-term financial plan stays on track.
Join Your Group RRSP
Your employer’s group RRSP is another important way to maximize that RRSP.
Many plans will have an employer match component. So, if you join the plan, you might contribute 3% of your earnings, and the employer will match your contribution. It’s an instant doubling of your contribution.
Furthermore, group RRSPs have a few other advantages:
- Contributions are made directly by payroll deduction on a pre-tax basis, which immediately reduces your tax burden.
- Lower management fees than typically available for individual accounts.
The CRA develops tax brackets to determine how much personal income tax Canadians will pay each year. The bracket refers to the tax rate that applies to a set income range. This is known as a progressive tax system.
For reference, Canadian federal tax rates* for the 2021 tax year are listed below (source: Intuit.ca).
on the first $45,142
on the next $49,020
$49,021 up to $98,040
on the next $53,939
$98,041 up to 151,978
on the next $64,533
$151,979 up to $216,511
on the portion over $216,511
$216,512 and up
*Note: I have chosen to illustrate federal tax rates only to illustrate the concept of tax brackets. Each province or territory will also have its own rates.
In simpler terms, the more money you make, the more tax you pay.
It also means that the higher your income, the more benefit you can obtain from making an RRSP contribution.
Using the handy RRSP tax savings calculator from Ernst + Young, we can examine what kind of tax savings an Ontario resident can expect on a $5,000 RRSP contribution at several income levels.
2021 RRSP Contribution
As you can see, the higher your income, the bigger the tax savings from your RRSP contribution.
Use the deduction when you get the maximum impact
Contrary to popular belief, you don’t need to claim your deduction right away.
You might be better served to “save” it until a future year if that suits your situation better.
Let’s assume that you expect your income to rise significantly next year, either due to a promotion or bonus. Your current salary is $50,000 but you expect it to double, to $100,000, next year.
We just illustrated the impact of RRSP contributions on higher income levels.
You have the option of making the RRSP contribution this year but not claiming the deduction until a future year, where it will likely have a more significant impact.
At the same time, your money has been invested in the RRSP. So the investments will grow on a tax-deferred basis, even if you aren’t using the deduction right away.