|Contributed by: martingale |
An RRSP is a tax deferral tool. While most people use their "registered retirement savings plan" to provide income in retirement, your RRSP can also be used just to defer taxes from one year to the next. This article will discuss the tax implications of contributing to, and withdrawing from, your RRSP, as a way of smoothing out your tax rate from one year to the next.
When you contribute money to your RRSP you are entitled to a tax deduction in the current year. Unfortunately, this is not a permanent tax reduction: The tax you avoided will come due eventually. In particular, you will have to pay tax on the contribution in the year you withdraw money from the RRSP. Typically, you withdraw money from the RRSP when you retire (and you will be forced to do so!). However, you could opt to withdraw the money from the RRSP sooner if you wanted.
Why it is generally good to contribute every year and keep your money in your RRSP
Ordinarily it is a bad idea to withdraw money from your RRSP. The tax protection of the RRSP allows for faster compound growth. Let's compare growth inside (untaxed) and outside (taxed) of an RRSP, with a hypothetical investment that pays 10% per year. If you decide to save the top $10,000 of your income, and your top marginal tax rate is 40%, you will pay the 40% tax and have $6000 to invest. If the investment pays10% per year, in the first year you will earn $600 but pay $240 in tax on it, leaving you with $6360. In the second year you will earn $636 and pay around $254 in tax leaving you with roughly $6732 after tax to spend. Clearly, it's best to leave money in the RRSP.
Were you to contribute that money to an RRSP instead, you would not pay tax on the $10000 in the first year, and be entitled to invest the whole amount. In the first year you'd earn a full $1000 in interest, and in the second year you would earn $1100. In total, you'd have $12100 inside your RRSP after the second year, but then, when you withdrew it, you'd have to pay tax on it. Assuming your top marginal rate is still 40%, you would pay $4840 in tax and be left with $7260: $518 more than had you invested outside an RRSP. For people who withdraw money in retirement it's typically an even bigger win than that, since their tax rate in retirement is usually lower than their tax rate during working years.
If you withdraw money from an RRSP you cannot just "put it back" later (unless you take advantage of the RRSP home buyer's plan, or use the RRSP moneyt o pay tuition). You are only allowed to contribute to your RRSP up to 18% of the previous year's income. You should be saving some money for your retirement every year (probably at least 18%!) and so any money you withdraw from the RRSP is money that is permanently unable to compound at the higher rate. However, some people, especially those with highly variable income, are in a special case where the tax advantage of the RRSP might be outweighed by the tax disadvantages of a variable income stream.
Why it is sometimes good to vary your yearly contributions, and even sometimes withdraw early from your RRSP
Suppose you are self-employed, and in your particular business, your income varies wildly from one year to the next. Let's say you land a contract worth $50k on average every 9 months. Your average yearly income is then roughly $66k per year. However, in any given year you either earn $50k, or $100k. Since your top marginal rate at $100k is much higher than at $66k you are unfairly taxed in the years you earn the higher amount. To some extent this problem should be correctable with proper accounting; but sometimes it cannot. In those years you could use your RRSP contribution limit to smooth out your income somewhat.
Let's say you earn $50k this year, and you know you will probably earn $100k next year. Last year you earned the average $65k. You cleverly decide not to make any RRSP contributions this year, and pay tax on the full $50k income. You save your $11,700 in RRSP room from last year and gain a further $9000 in RRSP on the $50k (your RRSP room grows by 18% of the previous year's income). Next year you make the full contribution of $20700 to your RRSP, reducing your $100k income to around $80, and dropping yourself down a tax bracket. Since the marginal tax rate at $80 is much higher than the marginal rate at $50 or $65k, this is a win.
You could smooth your income out even more by taking a withdrawl in the down years. In the subsequent year, when you earn just $50k again, you could increase your income for that year to to your average $65k by withdrawing $15k of the money you contributed to the RRSP in the previous year. While in general I would advise against doing this--it's better to save!--it does smooth out the income, and if you need that money to live, that's one way to do it, while reducing your taxes.
If you contribute money to the RRSP in 2005, and withdraw it in 2006, the tax consequence is that your 2005 income is lowered by the contribution, while your 2006 income is increased. This can be a valuable tool for self-employed individuals or contractors, whose income varies significantly from one year to the next. For example, if you earned $150,000 in 2005 but only $50,000 in 2006, you could lower your taxes, and average your income stream, by using an RRSP contribution to defer some 2005 tax until 2006.