How to make the right choices for your RRSP

Evolving your investing and savings over time

There’s a lot to like about RRSPs. Your contributions are tax-deductible. And your money can compound tax-sheltered for years, helping you build up a healthy nest egg for your retirement. But there are some things that may impact how and how much you invest.

Despite the benefits, contributing to an RRSP year-in and year-out isn’t always the best choice. It’s often better to let your age, income, and life-stage shape your retirement savings strategy.

Here are some things to consider when tucking away funds for your retirement.

The RRSP-TFSA dilemma

Which is the better tax-savings tool for you – a Tax Free Savings Account (TFSA) or a Registered Retirement Savings Plan (RRSP)? It’s a question that can be tricky to answer, especially when you’re early in your career.

Comparing your options

Whether stocks,ᶲ bonds,ᶲ mutual funds,ᶲ or GICs,ᶲ you can generally hold the same kind of investments in an RRSP and a TFSA.

Your RRSP contribution limit for a year is 18% of your earned income from the previous year, up to a maximum dollar amount that changes each year (less any pension adjustment). For the 2024 calendar year, that limit is $31,560.

When you contribute to an RRSP, you receive a tax deduction based on your marginal tax rate. That means the more income you earn, the greater the tax savings.

Once the money is in your plan it can grow tax-sheltered, which can turn into a sizeable sum over time. However, it’s not tax-free. Because RRSP contributions are funded with pre-tax dollars, your savings will eventually be taxed when you withdraw the money from your plan.

Where RRSPs shine is when your marginal tax rate at withdrawal time, usually retirement, is lower than when you made your contribution. But, if that isn’t the case, RRSPs aren’t nearly as attractive. That’s where the TFSA comes in.

For 2024, you can contribute up to $7,000 to a TFSA no matter how much you earn. As with RRSPs, unused contribution room can be carried forward indefinitely. So, if you’ve never or have infrequently contributed to a TFSA and you have been eligible to do so since their introduction in 2009, you can contribute much more in a given year. Consult your most recent tax assessment for the maximum amount you’re authorized for.

While TFSA contributions aren’t eligible for a tax deduction, because they’re funded with after-tax dollars, there’s no future tax liability. Plus, TFSAs are flexible. You can take funds from your plan tax-free to use however you wish, then recontribute those funds without penalty the next year.

Your best choice could change over time

With an RRSP, the higher your tax bracket, the greater your tax savings from a dollar of contributions. That means if you’re already earning a solid income, RRSPs are a sensible choice. For example, assuming a 40% marginal tax rate, contributing $1,000 to an RRSP would reduce your immediate tax bill by $400.

But what if you’re early in your career? When you’re in a lower tax bracket, there are two problems with RRSPs. Your contributions won’t generate much tax savings. Plus, it’s probable your marginal rate will be higher when you eventually withdraw those contributions, meaning more tax to pay.

For these reasons it can make sense to prioritize your TFSA when you’re younger, particularly if your annual income is under $40,000. You’ll still tax-shelter your savings.

At the same time, you can carry forward RRSP contribution room and use it to save tax once your income rises. Alternatively, you could make RRSP contributions, but hold off claiming the deductions until you’re in a higher tax bracket.

It’s always best to speak to your advisor before choosing where your next contribution goes. They can also help you decide if an alternative like paying down your mortgage or contributing to your employer’s pension plan is a better option.

Can your RRSP grow too big?

For anyone approaching retirement, or already there, having the comfort of a large RRSP can be a double-edged sword.

When contributing to an RRSP, it’s generally assumed you’ll see your income – and your tax rate – fall in retirement. But that’s not always the case.

If you’re like most Canadians, by the end of the calendar year you turn 71 you’ll convert your RRSP to a RRIF. Once that happens, your savings are subject to mandatory minimum withdrawals every year.

For example, if you have $1 million in a RRIF at age 72, you must withdraw at least $54,000, or 5.4%, from your plan and add it to your taxable income for the year. The minimum withdrawal rate increases every year as you age, reaching a maximum of 20% when you turn 95. What’s more, all income taken from a RRIF is taxed at your full marginal rate; the normal tax advantages given to capital gains and eligible dividends don’t apply.

Mandatory RRIF payments aren’t the only reason your income could be higher than you expect. You might have a generous pension or extra investment income spun off from an inheritance. In the end, your combined income sources could push you into a higher tax bracket.

More tax isn’t the only potential consequence from having an ample RRSP. For one, there’s the risk of the OAS clawback. Once your annual net income exceeds a certain amount, expect to pay back 15% of OAS benefit for every dollar of income above this threshold. There is a ceiling to that income number – at that point, you’ll lose your entire OAS benefit.

The income limit changes each year to account for inflation and other economic factors, but for 2024 the clawback begins once your annual income reaches $90,997. You’ll lose all OAS benefits at $142,609 (ages 65-74) or $148,179 (75 or older) annually.

Another consideration? Your estate. Having your surviving spouse or common-law partner inherit your RRSP or RRIF assets when you die can create more tax hurdles. Income earned on their now-larger asset pool could lead to a higher tax rate.

Once your spouse passes away, their RRIF balances are counted as income on their final tax return, plus, any additional property they hold is generally deemed sold at fair market value which may trigger capital gains taxes.

What you can do

Here are five ways to help avoid the drawbacks which can go with having a large RRSP.

1. Reorganize your investments

Not all investments are treated the same for tax purposes. That’s an important consideration when choosing how to divide your portfolio between registered and non-registered accounts for minimizing taxes.

For example, think about holding interest-bearing instruments like bonds and GICs, which are fully taxed, in your RRSP or TFSA. On the other hand, dividends from eligible Canadian corporations qualify for the dividend tax credit when earned outside a tax-shelter.

Don’t forget to keep enough cash and short-term money available in your portfolio to fund mandatory RRIF withdrawals. That way you won’t be forced to sell in a down market to come up with the necessary funds.

2. Tap your RRSP early

Conventional wisdom encourages retirees to fund expenses out of their non-registered accounts first, allowing their tax-sheltered assets to compound for as long as possible. But if you’re in a low-income year or you’re retiring early and have some time to wait to collect your pension or government benefits, it can pay to do the opposite.

Tapping into your RRSP in advance can help smooth out your income, reducing the likelihood requisite RRIF payments, pensions, and other incoming cash will bump up your tax rate or threaten your OAS benefits down the road.

3. Take advantage of your Tax-Free Savings Account

One way to start unwinding your RRSP is to make use of your TFSA. You can maximize your contributions using funds from your RRSP. Once those funds are in your TFSA, future income and growth will be tax-free to spend later or leave to your heirs.

Mandatory RRIF withdrawals force you to take a minimum amount from your plan, whether your need the income or not. One solution? Channel excess withdrawals to your TFSA to re-shelter those funds. Or, give the money to your spouse to contribute to their account.

4. Use life insurance to preserve your estate

Although your spouse can receive your RRSP or RRIF assets via a tax-free transfer when you die, it doesn’t eliminate any tax liability you leave behind; it only transfers the future bill to them.

To preserve the value of your combined estates, consider a joint last-to-die life insurance policy. When a surviving partner passes, the policy’s tax-free proceeds can be used to settle tax and other obligations, or, create a legacy for loved ones or a favourite charity.

5. Split pension income with your spouse

Sharing pension income with a lower-income spouse is a smart way to lower taxes, while helping you hold on to income-tested benefits and tax credits, including OAS.

The tax rules allow you to transfer up to 50% of qualifying pension income to your partner each year. What’s considered qualifying income depends on your age. If you’re under 65, payments from a registered pension plan – your employer pension for example – are eligible to be shared. At age 65 your options expand to include payments from a RRIF or annuity. The first $2,000 of income eligible for pension sharing also qualifies for the pension income tax credit.

Chart your own course

Your RRSP strategy shouldn’t be a set-it-and-forget-it proposition. It’s important to adjust your plan’s priorities as your life moves forward. Your BlueShore Financial advisor is ready to explain your options and help you decide what’s best for your RRSP – for now and for later. Contact us to learn more.