Savings & Investments

The RRSP Deduction – Should You Use It This Year or Carry It Forward?

If you have set up an RRSP (Registered Retirement Savings Plan) and made contributions to it, you’ve done one of the best things you can do in terms of employing tax strategies for reducing the amount of income tax you will have to pay.

But contributing to an RRSP (at as early an age as possible) is just the first step of this strategy; the second, and most important step, is to use your RRSP income tax deductions as effectively as you possibly can – which means “you got to know when to hold ‘em”, as Kenny Rogers sang. Carrying your RRSP deduction forward rather than using it in a particular tax year can provide you with even more income tax savings in the long run.

So how do you know when you should use your RRSP deduction or when you should carry it forward instead?

There are three basic situations where you would be better off carrying all or some of your potential RRSP deduction forward instead of using it all;

1. When you don’t have the income to justify using the deduction.

There may be years when you have a low income. You may be a student or experience a business loss. Or perhaps you move from full-time to part-time work or lose a job part-way through the year.

Whatever the reason, there’s not much point in using your RRSP deduction to bring down your income level if you don’t have much income in the first place.

2. When you know or suspect that you are going to make significantly more money the next year.

The key to using this strategy effectively is to know what increase in income is “significant” – and the answer to that question is that significant income is an increase in income that moves your income to a higher tax bracket, because the higher the tax bracket, the more income tax you pay. For 2013;

  • If you make $0-$11,038; you will be taxed 0% on it
  • If you make $11,039-$43,561, you will be taxed 15% on it
  • If you make $43,562-$87,123, you will be taxed 22% on it
  • If you make $87,124-$135,054, you will be taxed 26% on it
  • If you make over $135,054, you will be taxed 29% on it

(Keep in mind that these are the federal tax rates; each province/territory adds their own tax to federal tax.)

So the most effective way to use your RRSP deduction is to use it to lower your tax bracket, so you’re reducing the percentage of tax you have to pay on your income.

For instance, suppose that in 2013 you purchased an RRSP for $12,000. That same year, your income was $48,000. Looking at the tax on different tax brackets, this would be a good year to use your RRSP tax deduction because $48,000 puts you into a “higher” tax bracket.

But you shouldn’t use all of it in this case, but should claim only $4,439 of your $12,000 RRSP contribution  ($48,000 minus $43,561) – just enough to reduce your income to the next lowest tax bracket, moving you from a 22% tax rate down to 15%.  The rest you should carry forward, building up your RRSP deduction room for the next time you need to use it.

Now be aware that this example is simplified. To actually use this system to maximize your RRSP deduction, you have to take into account the provincial tax rates as well to know how much income tax you’re truly paying on your income, as the income tax rates in Alberta, for example, are very different than those in Ontario.

3. When you are approaching age 65 and worried that your GIS

(Guaranteed Income Supplement) benefit payments may be clawed back.

If you are nearing age 65 and think you may be eligible for Guaranteed Income Supplement (GIS) payments, you might want to put off claiming your RRSP deductions for several years and let them build up so you can claim them all at once when you’re 65.

RRSP deductions reduce your net income for tax purposes, so doing this could drop your income back down to within the GIS income level required to avoid having your GIS benefits clawed back.

Because the GIS is designed as an income supplement for people with low incomes, you are only allowed to earn $3,500 in net employment income (other than Old Age Security (OAS) and GIS payments) before GIS payments start to get clawed back – at a rate of 50 cents on the dollar.

So by “bundling” your RRSP contributions and claiming them all at once, you might be able to avoid the clawback for that year.

Image courtesy of typexnick.