Go ahead and tap that RRSP

Conventional wisdom says clients should contribute as much as possible to an RRSP and wait as long as possible to start taking withdrawals.

I’d like to challenge that conventional wisdom. In many cases, RRSP contributions are a bad idea. In others, making withdrawals long before the government-mandated age 72 are a good idea. It doesn’t sound right, but here are a couple of examples.

It’s not uncommon for a couple to pay off their mortgage in their 50s. At that point, the question becomes ‘what to do with their extra cash flow?’ Imagine a 55-year old wife earning $100,000 in Ontario with a projected defined benefit pension of $60,000 per year at age 65 and her 55-year old husband who currently earns about $30,000 per year with no pension.

If the husband has RRSP room that he hasn’t taken advantage of over the years, that might be the logical choice for their extra cash flow once the mortgage is gone. But if the husband is earning $30,000 and makes an RRSP contribution of, say, $10,000, his tax savings is only 20%.

In retirement, the husband will be able to claim half of his wife’s defined benefit pension on his tax return due to pension income splitting, so he’ll have $30,000 of income right off the bat. He’ll also be entitled to about $8,000 of Old Age Security pension at age 65 and $14,000 of Canada Pension Plan, assuming 2% inflation. This pushes his income up to about $52,000 per year without even factoring in his RRSP withdrawals after age 72. His tax rate at $52,000 is 31% and if his income including RRSP withdrawals is high enough, his Old Age Security may be clawed back to the tune of 15 cents on the dollar – an effective tax rate of an additional 15% on his existing 31% rate. That’s 46% total tax!

So was the tax deduction at 20% in his 50s worth the taxation at 46% in his 60s, 70s and 80s? In most cases, the answer is no, especially when you consider his $10,000 contribution may have grown to $20,000 by age 65, assuming 7% average annual returns. He’s not only paying a higher tax rate than the deduction rate, he’s paying it on a higher dollar amount than he originally put in.

But what about the benefit of the tax-deferred growth, you ask? Well, in Ontario, and most provinces for that matter, investing the $10,000 in Canadian dividend paying shares outside his RRSP will result in no tax on the dividend income for the husband due to the lucrative dividend tax credit. If he employs a buy-and-hold approach with Canadian common shares, he can effectively defer capital gains tax as well. Even if he does realize capital gains, which are inevitable, those are 50% tax-free. And if he wants fixed income, you can talk to him about Canadian preferred shares that pay dividends eligible for the dividend tax credit.

The case for early withdrawal

So, what about early RRSP withdrawals? Do they make sense?

Consider the same couple and imagine the husband retires at age 62. If his wife continues to work until age 65 and draws her pension at that time, the husband may have no other sources of income other than CPP (if he chooses to apply at age 62, though he can still defer payment until age 65).

His OAS pension cannot start until age 65 and he may have some non-registered investments generating taxable investment income. But unless these non-registered investments are significant, he could have next to no income at age 62 and therefore, next to no tax payable. We know his income is going to be $52,000+ at age 65 and he’ll be paying tax at a 31% rate. Why not consider “forcing” some income by taking RRSP withdrawals at age 62, 63 and 64?

In most provinces, including Ontario, the husband would pay virtually no tax on the first $10,000 of taxable income (although there are tax credits his wife may lose). Depending on the tax deductions and credits available to the couple, the tax implications of pulling $10,000 from the husband’s RRSP could be negligible, and every dollar of taxable income he has between $10,000 and $37,000 would be taxed at only about 20%.

So, think twice about having your clients follow the RRSP rules of thumb too closely. These and other tax shelters are powerful tools in the right circumstances, but can actually generate more tax without proper planning.