Every year comes the RRSP season. Advertisements will be bombarded your way until we reach the RRSP deadline and I wanted to discuss how to best best maximize your RRSP. “Maximize” being the key work here and not “optimize” – that’s for another post. I had an interesting discussion with my dad about RRSP over the holidays around the benefits of RRSP and it’s all about 2 things: how you use your tax credit and the tax free growth. Lets review those 2 critical benefits for a clear understanding on how to maximize your RRSP contributions.
RRSP Tax Credit
The RRSP tax credit is simple in that all your RRSP contributions (up to your maximum) provides you with a tax credit at the end of the tax year. Here are a couple of examples for 2 different incomes.
You’ll notice that for the same amount, the higher the tax bracket, the higher the tax credit is. It’s one of the reasons why you may want to reserve your contributions for when you are in a higher tax bracket.
What the scenarios outlined is that you get a tax break when you contribute to your RRSP but what it doesn’t show is what you do with the tax break and this is where you can truly maximize your RRSP. If you usually see your tax break as a gift, I would strongly suggest your reconsider because the tax man intends to collect it later on when you withdraw funds from your RRSP. Although it can be used to pay for your car insurance, home insurance or your trip to a sunny destination, it’s actually much better to re-invest it The age old dilema is whether you invest it (TFSA anyone?) or pay down your mortgage. Both options can offer the power of compound growth. My personal take is if you are early in your mortgage, pay down your mortgage for a little while, it will have a big impact over time. Otherwise, it’s really your choice; one has a guaranteed rates and the other has a potential investment return rate. In either case, you will benefit greatly compared with paying for insurance or any other spending.
Let’s look at some examples of what you can do with your tax refund.
RRSP Growth @ 4% for 25 years
I used the $120K example from the scenario above as it can be representative of a family income. As you can see, it takes hard work and a lot of savings to reach 1 million dollars. This example represents just the RRSP contribution and assumes you spend the tax refund.
RRSP Tax Refund invested in a TFSA
Same scenario as above but with the $4,070 tax refund invested in your TFSA. Little by little, your TFSA will grow. After 25 years, you would have $169,498. Not too bad if I may say. The growth is also simulated with a 4% annual compound growth which is probably conservative if you invest in equities. A good 10/10 dividend strategy should help you grow it faster due to the 10% growth in your dividends annually and you’d expect a company that can do that to also grow in value.
RRSP Tax Refund invested in your Mortgage
Here we apply the tax refund to your mortgage with a 3.5% rate (might not be realistic for 25 years but for immediate comparison it works). We apply the same $4,070 and you can see that you shave 6 years of your amortization for a total saving in payments of $18,864. For the last 6 years, you should really invest the tax refund to kick start your savings and you could reach $26,996 at 4% annual growth. If you are really good at not adjusting your life style once your mortgage is paid and you invest the same payments for the next 6 years with your tax refunds, you would have $144,161. That’s still $25,000 short but it’s possible with a strict budget and willpower.
The Mortgage + Tax Refund pays a total of $108,779 of interest total where as the default mortgage will pay $149,343. It’s a nice saving but after 25 years, what do you have to show? No extra investment and no extra equity … Something to consider.
RRSP Tax Refund invested back in your RRSP
Dividend Ninja commented on the post and asked about this option which I had overlooked. Thanks to Ninja, you can now see what re-investing your refund does to your RRSP nest egg.
The total assets land at $673,387.11 – no small change. The tax refund re-invested allows the contributor to increase the tax refund which increases the amount invested in total. The RRSP value is the same as all the other scenario but the re-invested tax refund ends up higher than a TFSA in this scenario at $256,928.03 compared with $169,498.85. That’s almost $100,000 greater.
If you compare investing your tax refund in your TFSA compared with accelerating your mortgage, you will notice that after 25 years, in both scenarios your mortgage will be paid with a possible clear winner depending on your ability to continue saving.
- With 25 years of TFSA contribution, your portfolio will have grown by an extra $169,498
- With extra mortgage payments, your portfolio will have by an extra $26, 996 (not taking into account the ~$1,500 per month possible investment form the mortgage payments)
- With extra mortgage payments and extra monthly payment in savings, your portfolio would have an extra $144,161
- With extra mortgage payments and extra half monthly payment in savings, your portfolio would have an extra $85,875
- With 25 years of RRSP re-invested tax refund, your portfolio will have grown by $256,928.03
RRSP Tax Free Growth
Tax free growth simply implies that your money can grow tax free but it’s important to organize your investments to maximize the tax free benefit. If you just want to compare investments from a tax perspective, a buy and hold strategy of an equity may be better outside of an RRSP than inside since all you have to do is pay capital gains when you sell where as you would pay your marginal tax rate when you withdraw from your RRSP. Tax free growth also requires growth It’s also quite important to understand which account you should use for different investments.
With the introduction of the TFSA, many now opt for a TFSA before a RRSP. Often time, it’s because the tax refund is not put back to work. Dividend Ninja just reviewed the dilema of investing in your RRSP or TFSA first. If you don’t maximize your tax refund, the TFSA wins in my book.
For families, I am introducing another way to maximize your RRSP. ALWAYS have the higher income spouse make the contribution when you can since the higher income will receive the tax break. The tax refund can be quite nice. All you have to do is open a Spousal RRSP and contribute to it just like you would do for yours. Let’s look at a scenario.
- Wife makes $90,000 with a marginal tax rate of 38.29%
- Husband makes $70,000 with a marginal tax rate of 29.70%
As you can see, there is almost 10% different in taxes. Assuming they each put $5,000, the individual tax refund is:
- $1,897 for the wife
- $1,485 for the husband
- A total of $3,382
Now if we let the wife take a $10,000 RRSP contribution, her tax refund would be of $3,522. That’s an increase of $140 dollars. If you start increasing the RRSP contributions, the tax refund will also increase, especially if you change tax bracket.
I have to say that it was a bit of an eye opener to run the numbers. I actually quite like the idea of using my tax refund for my TFSA. I have been a big fan of the TFSA to the point that I have been doing that first and then my RRSP but I may just change and adjust to leverage my tax refund for my TFSA.
Readers: Are you surprised by the mortgage and TFSA comparison?