Why Your RRSP is Worth Less Than You Think

Registered Retirement Savings Plans (RRSPs) are an excellent tool for Canadians to save for their retirement by deferring taxes. However, many people overestimate the true value of their RRSPs and the income that they will provide in the long run. By forgetting that taxes will need to be paid in the future, Canadians fall into the trap of spending their refund and miss out on the true benefits of RRSP contributions.

RRSP contribution deadline

The deadline for 2022 RRSP contributions is March 1, 2023. This means that individuals have until this date to make contributions to their RRSP to receive a tax deduction for the 2022 tax year.

Your RRSP account is pre-tax

It's important to keep in mind that the balance displayed on your RRSP statement is not the same as what you’ll be able to spend in retirement. When you withdraw money from your RRSP, it will be taxed as income according to your marginal tax rate. This is especially important to keep in mind for individuals who are nearing retirement and have a substantial amount in their RRSP.

As an example, if you expect to have a 25% tax rate during retirement and withdraw money from your RRSP evenly, a $500,000 RRSP balance would result in only $375,000 being available for spending after taxes have been paid. If someone were to withdraw the entire amount in only a few years, there would be even less for spending after-tax.

Benefits of deferral

The awareness of how much tax will have to be paid on RRSP withdrawals can be discouraging, but it is important to know that RRSPs are still a very powerful tool, provided that you know how to use them.

One of the biggest benefits of RRSPs is the ability to defer taxes until retirement when your tax rate may be lower. By contributing to an RRSP, you reduce your taxable income in the current year and will only have to pay taxes on withdrawals in retirement. If your income is lower during retirement, your withdrawals may be taxed at a lower rate.

If the difference between your current tax bracket and your tax bracket in retirement is 10%, then your current contributions result in a 10% tax savings.

Let’s take a look at an example of Brian, who is a few years away from retirement:

Brian lives in Manitoba and plans on working until the end of 2026. His marginal tax rate will be 37.9% until retirement, at which point he expects his taxable income to drop, putting him in the 25.8% bracket during retirement.

By making an extra $3,000 RRSP contribution in 2023 and later withdrawing it throughout retirement, he can potentially save 12.1% in tax, which is the difference between the two brackets (37.9% - 25.8%). This results in a tax saving of $363 on the 2023 contribution.

This deferral can be a great way to maximize your retirement savings, especially since the taxes you save now can be reinvested and grow over time.

Don’t spend the refund

A common mistake in retirement planning is making a contribution to an RRSP and then spending the refund that it generates.

Going back to the example of Brian, his 2023 contribution will increase his tax refund by $1,130 ($3,000 x 37.9%). If he spends the increased refund right away, then he won’t have money set aside to pay the taxes that will come due in retirement.

He will still get the benefit of withdrawing the money later when in a lower tax bracket, but will likely be caught off-guard by the taxes payable in retirement. Instead, he should use the refund to make further contributions to retirement savings.

RRSP contributions should be used to defer taxes to supercharge your retirement savings, not to create a refund for current spending.

Create a plan to get the most from your savings

RRSPs are a valuable tool for Canadians to save for their retirement, especially during the final working years when income is typically at its highest. Understanding your expected income in retirement will help you to estimate your future tax bracket and calculate the potential tax savings from your RRSP contribution. Estimating retirement income and tax brackets can be challenging, so getting assistance from a financial planner may be helpful for some.