RRSP Followup

I had never thought I’d get into “financial” blogging. After my first RRSP (Registered Retirement Savings Plans) post that was meant to just give some background around our writings, I didn’t expect to write more on any aspects of saving for retirement. By no means am I an expert, I just learned to read the syllables. And there is a world of experts out there blogging on it.

However, I received e-mails with questions from another newcomer to Canada asking me to explain some of the terminology I was using in this post. “Define higher brackets” in “Or should I say, RRSPs only make sense if you are in a higher tax bracket when working and know that you’ll be in a lower tax bracket in your retirement years, when you’ll need your RRSP savings”, he asked. First, I should change my statement a bit. In my opinion, “RRSPs make the most sense if you are in a higher tax bracket when working and know that you’ll be in a lower tax bracket in your retirement years, when you’ll need your RRSP savings”. This is due to the compounding effects of investment income. And no, I’m not getting into that but feel free to look it up.

So here I go, trying to explain in plain language what I myself struggled with at the beginning of my Canadian life journey.

The Canadian tax system is unnecessarily complicated and I wish there was a governing party with the guts to focus on simplifying it, instead of thinking about re-election. There are many tax credits for social and economic programs that are built into, and add complexity to, the income tax system. We will ignore them here, or the post will become a book (or rather several books, videos and university-level courses).

The tax brackets determine the percentage of tax one pays (tax rate in CRA – Canada Revenue Agency – terminology). The lower the tax bracket, the lower the tax rate (percentage), so tax rates increase with income like steps on a staircase. Everybody with taxable income pays tax at the Bracket 1 rate for income falling into Bracket 1, and if they earn more than the Bracket 1 maximum, they pay tax at the Bracket 2 rate on the portion of their income falling into bracket 2, and so on. Hence, somebody with income in the highest bracket does not pay tax at the highest rate on their entire income.

From an income tax perspective there are two level of taxes: federal and provincial. As of time of writing there are 5 federal tax brackets. Each province has its own taxes and their tax brackets are different, which adds to the complexity. But the principle is the same. You will just have a few more tax brackets. If we add the Ontario tax brackets to the equation it gets us to 11 brackets, and therefore 11 tax rates (percentage) for Ontarians. Hold on to your hats…there is a proposal for Ontario to have 7 tax brackets by the end of the year.

One of the most important features of RRSPs is that your contributions reduce the amount of income on which you pay tax today, but any withdrawals later are included in your taxable income. For the government, it’s “pay me now, or pay me later”. This is why RRSPs are known as tax deferral plans.

One of many sites you can find the current and past tax brackets (federal and provincial) is the government of Canada website

One can find a lot more tips and information in: taxtips.ca

Now I have to say that all accountants think in a very complex and quite detailed framework [they also have absolutely no sense of humour – A]. So even for someone like me with a math background, it takes a lot of effort to understand Alex who has an accounting background, [but hasn’t lost his sense of humour]. We often have heated discussions about simplicity and conciseness (me) and using the right terminology (think accounting) and details (Alex). After my first go at writing this post I thought it was clear and simple, but of course not even close to reality. Again, the tax system is made ridiculously complex and I was trying to explain it to a newcomer with no reference to any of this complexity, free brain cells to understand it, or money to pay someone to do his taxes and retirement planning.

Alex looked into it and had a second go, in which I got lost. So, after some back and forth we created a fictitious character Sam with only 3 years of work, a very simple 2 tax brackets example.

Well, tax and accountant police, I know this is a very simplistic explanation, but if this makes it clearer to one newcomer I’ll be happy.

RRSP example:

For simplicity though let’s just consider our 2 tax-bracket fictitious world (PseudoCanada).

1. Income from $1 to 40K has tax rate of 20% – tax bracket 1: [$1 to 40k]
2. Income over 40K pays 30% in taxes – tax bracket 2: [>40K]

Also, let’s take a look at the situation of Sam who just began working in PseudoCanada. Sam can be a newcomer or a new graduate. We’ll look into his first 3 working years.

Year 1: Sam earns 60K therefore he is in tax bracket 2. He has no RRSP contribution room yet, because it is based on your earnings the previous year(s).

Sam’s basic tax is $14,000 (20% of the first $40,000 plus 30% of the other $20,000 of income).

Year 2: Sam again earns 60K. He can contribute up to $10,800 (18% of Year 1 earnings) to an RRSP. He uses this opportunity and contributes $10,000. His taxable income is now only $50,000.

His basic tax this year is $11,000 (20% of the first $40,000 plus 30% of the other $10,000 of income).

The idea is that Sam invests the RRSP money and it grows over time until Sam retires and starts withdrawing it and pay tax then. But for now, let’s try to keep it simple (again, nothing is simple in the Canadian income tax system).

To make it more understandable, let’s not wait until Sam is in retirement age.

Year 3: Sam has no work. To pay his bills he withdraws his RRSP contribution from year 2. We’ll assume that any investment growth is left in the RRSP. His taxable income is $10,000.

Sam’s basic tax is $2,000 (20% of $10,000).

Now let’s compare Year 1 with the total of Year2 and Year 3:

Year 1 taxable income is $60,000, resulting in income tax of $14,000

Year 2+3 taxable income is also $60,000, resulting in income tax of $13,000

Sam saves $1,000 in income tax by contributing in his eligible high-earnings year and withdrawing it when he has lower earnings.

We hope this helps, just remember that while the example accurately reflects the concept it is quite far from real life.