Delaying your RRSP Deduction Could Pay Off Big

We like to read a few Canadian personal finance websites and one thing that everyone can agree on is that you are most likely better off maxing out your TFSA before contributing to your RRSP if your income is below $32,500 or so.  One thing I didn't agree with was that you shouldn't take the RRSP deduction, I thought that the compounding of the tax refund would offset the additional gains from a higher tax reduction in the future.
    For the most part, we couldn't be any more wrong and we quickly realized that after we calculated the compound rate of return needed to match the results of waiting for a higher tax reduction in the near future.  Basically, risk free too, assuming you do make it to a higher tax bracket.
    What we did was we took a $1,000 RRSP expense in 2016 for someone that earned $32,500.  We took the result of taking the deduction in 2016 at the $32,500 tax bracket and the result of taking the deduction at the $50,000 tax bracket in 2017, 2019, 2021 and 2024.  What we found was depending on your province of residence you would need to earn a compound rate or return between 29.7% and 83.6% if you were able to take the higher deduction the next year, a rate of return between 9.1% and 22.5% if you were taking the higher deduction in three years, a rate of return between 5.3% and 12.9% if you were taking the higher deduction in five years and a rate of return between 3.3% and 7.9% if you wait eight year to take the higher deduction.
    The reason there is such a big difference in the RRSP deduction with the $32,500 and $50,000 tax brackets is the same reason why a family that earns $9,000 more than you, might be paying less income tax than you next year (now that income tax splitting for Canadian families is over).  At the $45,282 income level, your marginal tax bracket for federal income taxes will increase 36.7% ((20.5% - 15%) ÷ 15%) = 36.7%.


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Compound Rate of Return Needed to Match your RRSP Deduction Today vs Deduction at a Higher Tax Bracket in the Future

Below we have the compound rate of return needed to match a $1,000 net RRSP expense in 2016 which is deducted in the 2016 tax year at the $32,500 bracket to equal the tax deduction in a future year at the $50,000 tax bracket in your respective province.
    Important Note: This a net $1,000 RRSP expense for the 2016 tax year.  For example, a $1,384 RRSP deduction in MB at the $32,500 tax bracket would give you a $384 tax refund so a net expense of $1,000.  If you decide to take the deduction for 2016, you will have to grow the additional $384 into $498 by the time you are in the $50,000 tax bracket in order to come out ahead ($1,498 deduction x 33.25% tax bracket = $498 refund at the $50,000 tax bracket, which works out to the original $1,000 net expense in 2016, if you decided not to take any RRSP deductions in tax year 2016).
    Basically, this an apples to apples comparison on actual money invested.  The same amount of funds that is taken from your wallet after deductions is taken into consideration, which when you think about it, is the actual cost of the RRSP.



Province 

1 Year

3 Years

5 Years

8 Years

BC

56.6%

16.1%

9.4%

5.8%

AB

31.8%

9.7%

5.7%

3.5%

SK

43.6%

12.8%

7.5%

4.6%

MB

29.7%

9.1%

5.3%

3.3%

ON

83.6%

22.5%

12.9%

7.9%

QC

47.9%

13.9%

8.1%

5.0%

NB

66.5%

18.5%

10.7%

6.6%

NS

38.3%

11.4%

6.7%

4.1%

NL

67.7%

18.8%

10.9%

6.7%

PE

42.6%

12.6%

7.4%

4.5%




Credit Card Nerd Math

Okay, this might get a bit too much nerdy, but we just got to do it.  We do this, so that you know how we crunched our numbers and if we did make a mistake, it would be easy to spot and you can let us know.  Also, we do things differently, so if you don't see how we calculate it, then you could calculate it yourself and think we are completely wrong.
    We used a $1,000 RRSP expense and used the deduction at the $32,500 and $50,000 tax brackets to keep the calculations simple.  Only PEI had a tax bracket that would be affected by the deduction.  We also decided that we will have a net $1,000 RRSP expense in 2016.  This changed a few things, but most importantly it meant dollar for dollar, your net RRSP expense would be the same and made in the same year.

If you decided to take the RRSP deduction in 2016.  Your RRSP contribution would be more than $1,000.  Why, because your RRSP deduction would increase your tax refund.  We took the amount that you need to contribute to have a $1,000 net expense.  For example, in Saskatchewan with a $32,500 income, a $1,351 RRSP deduction would increase your tax refund by $351, so a $1,351 RRSP deduction result in a net expense of $1,000 in 2016.

If you decided to take the RRSP deduction in a different year.  Your RRSP contribution would be only $1,000 in 2016.  Your RRSP contribution would not increase your tax refund, because you wouldn't be using the RRSP deduction this year.  Now we will figure out what contribution will be needed to zero out the tax refund at the $50,000 tax bracket in Saskatchewan.  An extra $504 RRSP contribution would balance out the RRSP deduction for a $0 net additional RRSP expense.  For example, in Saskatchewan a $1,504 RRSP deduction would increase your tax refund by $504, so a $1,504 RRSP deduction resulted in a net expense of $0 that year.

Now we will determine the compound rate of return needed to match the benefit of a higher tax deduction.  We used a compound annual growth rate calculator that we found online.  We used $351 as the beginning value, $504 as the ending value and ran it for 1, 3, 5 and 8 years.  We ignored the first $1,000, because in both examples, there is a minimum $1000 RRSP contribution in 2016.
    If you want to know how much you need to contribute in order to have a net RRSP expense at your income level in your province, all you need to is go to our provincial tax rate web pages and find out the "amount needed to net a dollar" and multiple it by your intended amount you want to spend this tax year.
    If you think you will be moving up the tax brackets relatively soon, then you can also quickly figure out how much you would need to earn annually inside your RRSP by using the compound calculator.  All you need is the estimated number of years, the amount needed to net a dollar (minus the 1) in your current tax bracket for the beginning value and the higher tax bracket (minus the 1) for the ending value.