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.

Examples | With RRSP | Without RRSP | With RRSP | Without RRSP |
---|---|---|---|---|

Income | $60,000.00 | $60,000.00 | $120,000.00 | $120,000.00 |

RRSP | $5,000.00 | $0.00 | $10,000.00 | $0.00 |

Taxable Income | $55,000.00 | $60,000.00 | $110,000.00 | $120,000.00 |

Taxes (BC) | $10,359.00 | $11,844.00 | $29,294.00 | $33,364.00 |

Disposable Income | $44,641.00 | $48,156.00 | $80,706.00 | $86,636.00 |

Paid Taxes | $11,844.00 | $11,844.00 | $33,364.00 | $33,364.00 |

Tax Refund | $1,485.00 | $0.00 | $4,070.00 | $0.00 |

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.

## Spousal Contributions

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.

## Thoughts

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?

PIEThis post rocks! amazing job,and thanx for the mentionOnly one consideration.. Obviously at 60K there is a real tax benefit to utilizing the RRSP, whether it is either “maximizing” it, or “optimizing” it. Have you crunched the numbers for those that don’t earn 60K per year, but are in the 30K or 40K range? Or does the same principle apply in your opinion? just curious.. An excellet post!

Cheers

The Dividend Ninja

@Ninja

I can run the numbers here too but I think the lower the income the less benefits you would have since the tax refund is not as big. This is really the key of a RRSP in my opinion; how you utilize your tax refund. Especially considering the power of the TFSA.

PIEThe other scenario of course, is taking your RRSP refund and rolling that back into the RRSP. I’m sure somebody has already asked this, but I would love to see the numbers on thatCheers!

@Ninja

Good one. I did not think about this one. My mind is geared a little towards TFSA these days However, based on the simplistic math, it will be higher than TFSA simply because the same rate was used and you perpetually increase your tax refund. It should be quick to run the numbers as I still have my spreadsheet.

@Ninja

I ran the numbers for the scenario you mentioned and the total is $100K larger if it’s re-invested in the RRSP for a total of $673,387. I am going to add the graph to the post as it is a very good option to be aware of.

PIEI didn’t realize you had updated the post, that makes a huge difference! Of course you would have to withdraw the RRSP at your fully taxable rate – but it still looks like you would come out ahead with the RRSP over the TFSA, even after taxes Is that what the numbers tell you?Cheers!

@Ninja

Thanks for mentioning that option and coming back My spreadsheet was still warm, so it was easy to do. It’s definitely a big one to be aware of. I don’t know about the tax rate, I really focused on the growth but it would be interesting to take a case study and assume a 4% withdrawal rate of a hypothetical portfolio.

Great post.

I’m impressed by the numbers. Reinforces with me, the TFSA is utterly powerful.

We will be putting our tax refund, into my wife’s TFSA for sure. We’d like to max it out for 2012.

@MOA

That’s a good plan you got. I don’t get a tax refund since my taxes are all adjusted at source. It makes it really hard to execute what I have outlined … I just put some extra money aside and then I decide where to put it. Soon I’ll be setup to trade in my wife TFSA and I can start filling it up. I got some catchup to do there … $20K in fact.

I can’t wait for the TFSA limit to be increased. Would you still do RRSP if you could put up to $20K per year in your TFSA?

Wow that is mind boggling!

So you’re saying that there isn’t much point in increasing your mortgage payments (e.g. by putting in your RRSP return)?

That’s huge!

Well that gives me a bit more peace I suppose- I will rest easy knowing that when I get my tax return I’ll fill up my TFSA.

@YT

Isn’t it? I did not expect that outcome either. Obviously, the interest rate probably has a factor here but I don’t see the interest rates going up in the coming years to crazy level anyways. Now, don’t get me wrong but early in your mortgage, you will see the biggest impact due to the way interest is calculated on your mortgage. If you make bi-weekly payments, you save almost 4 years. My experience has been that one time lump sum, don’t make as much of a dent compared with increasing your payments slightly.

I was not really looking at how to accelerate a mortgage but I would say that the first 5 years is when you can make the biggest impact.

@PIE,

Sounds like you’ve got a good plan ready to execute as well

I would probably increase my taxes at the source, and not put ANY money into the RRSP – if the TFSA limit was $10 K or $20 K per year.

Your question was very timely – since I’m currently writing a post about that on my blog. I will be referencing this post since it was so well done.

How about you? Same question?

@MOA

Simple, TFSA all the way. No gimmick around taxes in retirement.

I paid out our mortgage about 5 years ao . It was first priority, as i don’t like to own money

I;m maxing my and my wife TFSA, also my wife’s RRSP is maxed out and I still have a room. RESP of our kids also maxed up. This is the plan continue to max my RRSP.

P.S. BTW, the final dividends we got in Jan is $909 (include $28 from MF and exclude RESP MF dividends)

@gibor

Thanks for your comment and sharing! Well done my friend! Very impressive. I have not been doing as great with RESP though … What’s your order? which do you do first? do you do monthly or lump sum and you be done with it.

$909 in a month is great! is that your average? do you DRIP or wait to re-invest?

@PIE, for RESP I’m doing lump sum. I missed several years and now I’m catching up. This year last 5K contribution for my son (he’s 16) and regular annual contribution for daugther.

January dividend was bigger than usual, as I added position to RCI.B and got div from some of my biggest holdings BCE, PM, BNS. In Feb I expect a liitle bit over $600 (BMO, RY, ABT etc)

If I can I DRIP, but sometimes it’s impossible for example CM doesn’t allow me to DRIP VEA or I don’t have enough div to buy 1 share (ex. TD).

PIE, did you do any new buys?

Thanks for the good article. As Ninja wrote, it’s also very important to take into consideration the taxes paid when withdrawing from your RRSP account vs tax-free withdrawal from a TFSA. Another consideration is Old Age Security. Once your retirement income reaches a certain level, OAS is reduced. While witdrawing from a TFSA does not impact OAS benefits, RRSP withdrawals can.

In the end it all depends on how poor or rich you intend to retire.

Cheers

First of all, congratulations on an excellent website..this is my first time posting here (I think)!

I’ve got a question about a basic RRSP rule that, if true, is mind boggling to me and not sure why it’s not publicized more…

It’s the concept of asking your employer to directly deposit to RRSP on your behalf versus you paying tax on it first and then getting a refund after contributing yourself. Inherently, you would assume that these two approaches would get you the same result ultimately (barring the time difference). But in my simple example below, it results in a huge difference:

Let’s say the individual earns $200K per year and is obviously in the highest tax bracket (46.41% in Ontario). Now, let’s say this individual is due for a Bonus of $40K. The individual plans to contribute this to his RRSP ultimately.

Approach 1

He let’s the employer pay the amount to his bank account thereby paying tax at his marginal tax rate of $18,564 and netting $21,436. He then contributes this $21,436 to his RRSP and gets a tax refund of $9,948 ($21,436 * 46.41%). Therefore, his total benefit out of this is $31,384 ($21,436 + $9,948).

Approach 2

He simply directs his employer to contribute to his RRSP directly thereby foregoing all tax deductions, etc. and as such his net benefit is full $40,000!

Difference is $8,616 between the two approaches. The concept is the same for smaller amounts as well. Am I missing something here?

@ V S

I like your thinking. Approach 2 is the best but there are limitations such as how much you are allowed to put in your RRSP. I also know that some companies do not allow you to contribute more than 75%. I am not sure if it’s a company policy or a tax limitation imposed.

In the end, it’s always better to get your tax adjusted up front and work towards not receiving a refund. It’s actually my case. I don’t usually receive a refund, in fact, I usually have to pay taxes although a small amount. It’s because I include all my refunds up front such as my kids, spouse and RRSP contribution deduction.

Thanks! With respect to the limitation, as long as you are within your contribution limit there is no imposed limit by the tax authorities. Yes, the flexibility your company allows is definitely key. The above scenario is what I actually did in 2013. I was going to receive a large bonus and instead of cashing in and then depositing later into RRSP I asked the money to be directly deposited into my Questrade RRSP account and it all went very smooth. Later on I had some extra vacation days and I wanted to cash it out and when I probed my boss again, he was hesitant in depositing vacation payout straight into RRSP. I don’t think there would be any reason to not allow that … so that’s where I think that the employer’s flexibility is key.

On a second thought, I wonder if all this trues up at the time of tax filing anyway, since in both scenarios the RRSP contribution by the employer would be reported as a taxable benefit on my T4 along with the respective tax deducted, if any!