Ah, tax season is upon us and like a good little worker B you are likely swarming to top up your RRSP contribution. After all, the ~30% return is nothing to swat at, and deferring your taxes is almost always a good idea. However there are a few excellent reasons you may want to hold off on dropping that hard earned money into the RRSP portion of your Honey Pot.
Yeah, You’re Broke
The first, and most common reason, is because your net earnings (your gross earnings minus any tax deductions) are low. This could be because you have an abundance write off’s this year (that blog you started costed a lot more than you were expecting), you didn’t work part of the year, worked part time , or perhaps you are just starting out in your career and haven’t yet worked your way up into a $35,000+ /year job.
Every year you’re allowed 18% of your earnings to go to an RRSP, and if you choose to not use it, you can still contribute the amount in a future year. If your earnings are less than what you expect to be making in retirement, you could actually end up paying more taxes*, if you contribute to your RRSP this year.
This is due to the marginal tax rate -the highest tax rate you pay. The chart below shows the income tax payable in BC, the other provinces have comparable rates, for 2019 (for 2020 the tax rates are remaining the same).
GROSS INCOME ________________ TAX RATE
Should I Work Overtime for RRSP contributions?
So, your first 40,707 is taxed at 20% and the next dollar earned is taxed at ~23%, and so on. The same idea works in reverse with an RRSP. Contributions to an RRSP pay back, via your tax return, at the highest tax rate first. Then they work their way down the scale.
Also, you can see that when you work overtime and get pushed into the next tax bracket, you really only get charged somewhere between 1.8 – 5.5% more income tax. That’s only on the dollars that are pushed into the next bracket. Therefore, don’t be afraid of working overtime due to income tax reasons.
You Have Really, Really Ugly Debt
Having not yet cured yourself of the Really, Really Ugly Debt, or as others refer to it -Credit Card Debt, is the second. If this affliction still ails you, cure it first.
Trying to attain early retirement while maintaining a balance of Really, Really Ugly Debt is akin to setting off to sea with your anchor down. No matter how hard the winds blow, how hard you paddle, how many possessions you throw overboard, -you’ll have an easier time convincing Triple B to invest in banana skin launchers for cars than be able to grow your Honey Pot… Wait, actually that’s a pretty good idea; you’ll have an easier time convincing Triple B to use a clothes dryer on a summer day, there that’s better ;).
The Al Bundy Maneuver (The RRSP Maximiser)
Married… with children. There’s no tax advantage to being a shoe salesman, yet. But, if you have children, or plan to have children in the not too distant future, there is a very important reason to hold off on your RRSP contributions.
This is one of the secrets to retiring early in Canada. The Canada Child benefit is so powerful -A parent with 2 kids can pay the mortgage payments on a $230,000 house**. You are eligible to receive $553.25 per month for each child under 6, and $466.83 for kids aged 6-17, tax-free. Most provinces also have a tax-free benefit on top of this of around $100-$200 a month.
Input your best estimates in this calculator and see what you will get next year. The payments run from July to June of the following year. Now adjust the net income amount down to $31,120, the federal maximum benefit amount, and see what the difference is.
You’ll find net income amounts between $25,000-$35,000 give the best return. You’ll also find you get a few other benefits like GST rebates, Workers Income benefit, Climate Tax benefits etc.
While I don’t want to encourage you to toss your birth control out the window, I do urge you to spend some time researching. For instance, how to best take advantage of the programs available. You can save up some contribution room by not contributing to a RRSP. Alternatively let your savings grow in a TFSA, a tax sheltered account.
This has a couple benefits. Firstly, it allows your money to grow without having to pay any capital gains taxes. Secondly, any money you pull out of a TFSA can be put back in, without penalty.
If you max out your TFSA contribution room then allow it to grow above the current maximum amount, currently $69,500, you can later pull it out to contribute to an RRSP. And still be able to put that money back in, even if its above the $69,500! This is the only way to earn more contribution room in a TFSA, which becomes very important when we retire.
The Magic Number
Whew, that’s a lot of numbers… What we want to do is take our savings and contribute them to an RRSP, when it’s most advantageous. We need just enough to bring us down to that ~$31,000 range. The exact amount will depend on your specific circumstances. Feel free to comment or email me via the contact us form below, if you’d like help figuring that out.
The first year is the toughest, but it gets easier from there! In subsequent years you can save the benefits you receive, along with your tax return. Then add them with your monthly savings, and repeat the cycle. The Al Bundy Rule*** works as long as you have RRSP contribution room, which you can find out here.
A Worker B example
Sometimes it’s easiest to see it all laid out in a fictional example.
The Worker B, whom we will call Buzz AllDreamin, is 38 years old (but has kissed a girl****). He makes 80,000 a year. Buzz has 2 kids aged 3 and 5 (named lil’buzz and kinder’bee respectively).
He checked his RRSP contribution room here. Buzz found out he has $125,000 left to contribute. Seemingly as a result of having his head in outer space and forgetting to plan for retirement all these years.
However for the last 2 years, after he started reading this blog, he has been saving about 50% of his take home pay each month. This works out to $2000 a month, 24,000 a year. He placed this in his TFSA and invested it in an ETF returning 7% a year. Therefore, he currently has $53,661.68 in his TFSA.
This is what to do
1st Year: Buzz talks to his accountant and finds out he needs another $30,000 to bring his net income down to $31,000. This allows him to get a $12,000 tax return, and $13,000 in benefits due to his low income and children. His RRSP contribution room drops to $95,000, but then increases by 18% of his income ($80,000 x .018 =$14,400) back to $109,400.
2nd Year: TFSA starts at $23,661.68. He adds the $12,000 tax return to it, along with the $1083 in benefits ($13,000 / 12 months= $1083.33/month) and the $2000 a month he is saving. This is all invested in a ETF returning 7%.
At the end of the year he has $76,445.28 in his TFSA and $32,168.70 in his RRSP, totalling $108,613.98. He continues this cycle, dumping his savings into his TFSA then into his RRSP, for a few more years. He can take advantage of his spouses RRSP and TFSA if needed.
8th Year: Buzz checks his accounts and realizes he has way more than enough to retire using the calculation (Yearly expenses x 25 = Amount needed to retire). By becoming a Buy Boss’r he was able to get his expenses down to $28,000 a year. $28000 x 25 = $700,000. He hands in his 2 week notice and begins work on his spacecraft.
You’re No Longer Broke
This example shows the power in the expression “It’s not what you earn, its what spend“. Father always drilled this into our heads. So give your children a big hug, if you have been so fortunate, and start planning out the next few years. Next we will start looking seriously at some ways to cut our costs while still living outrageously happy lives. See you there!
What the wise man does at the beginning, the fool does in the end.Warren Buffet
*We will discuss a method to substantially reduce your taxes in retirement in a future article, which can make this a moot point.
** Based on 5% down, 3.24% interest rate, 25 year mortgage.
*** I may have to change this rules’ name, if Al finds out.
**** Not Sorry for all the canuck references.