Using RRSP Contribution Room to Avoid Taxes

In a comment on a recent post, AS requested information about an RRSP strategy I alluded to.  In the title, please note that I refer to AVOIDING taxes (which is legal and encouraged), not EVADING taxes (which is illegal and can get you sent to jail).  Please also note that I’m not an accountant or tax specialist, and although I’m fairly sure this is ok to do, I could be wrong (my numbers below are particularly suspect).  If anyone knows more than I do, please post any clarifications in the comments.  Also, I’ll acknowledge up front that there would be a fairly limited number of people who would be in a position to benefit from this.  Finally, Derek Foster presents a very similar strategy in his new book, so check that out if you’re intrigued by this and would like to read another take on it.  Tim Cestnick, Where Does All My Money Go? (Preet is Mr. RRSP), and  Efficient Market Canada each have more information about this idea.

We’ll all, at some point, probably be in the situation where our income will drop substantially compared to the year before.  Usually this happens when you retire (since you move from a higher working income to a lower pension), but can also happen if you get laid off (not as much fun), become a stay-at-home parent or go back to school (this happened to me).  If you know this is going to happen ahead of time, it becomes tempting to try to figure out a way to move some of your income forward, since you may be in a lower tax bracket in the second year.  Unused RRSP contribution room lets you do exactly this.

Say an Ontario man was earning $100,000 / year and was planning to head back to school.  While at school, he expects to continuing working part time and will earn $40,000.  Say he has $20K unused contribution room in his RRSP.  Using the 2009/10 tax rates, he’ll be going from a 43.41% to a 24.15% marginal tax rate.  Say on March 1st, 2010 (the RRSP contribution deadline for the 2009 tax year) he contributes the full $20k that he has in contribution room to a RRSP savings account.  This will save him (give a refund) of:

0.4341*(100,000 – 81,941) + 0.3941(81,941 – 80,000) = $8,604.36

After his taxes are submitted, he can then withdraw this money from his RRSP, at which point he’ll pay a withholding tax (like when the government withholds part of your paycheck).  HOWEVER, the withdrawal will actually be taxed as income in the year he withdrew it 2010 (he’ll get some of the withdrawal tax back when he reports it on line 129).  If his other income is $40k, he’ll incur a tax penalty of:

0.3115 * (60,000-40,726) + 0.2415 * (40,726-40,000) = $6,179.18

Therefore, overall he’s netted a tax savings of $2,425.18.  If his income in the first “high income” year was higher, or if his income in the second “low income” year was lower the benefit would be even greater.

There is a cost to doing this.  In this example, $20K of his RRSP contribution room is gone forever (you don’t get this back when you make an early withdrawal).  Derek Foster doesn’t like RRSPs and I’ve never been consistently in a high enough tax bracket to really benefit from them, so for us this isn’t that big of a deal.  HOWEVER, for most people lowering your income every year and allowing the funds within the RRSP to compound faster through tax-free growth is VERY worthwhile.  Burning $20k of contribution room to save $2.5k in taxes is of questionable benefit.

Obviously if the person in question were actually going back to school (or using the withdrawl to buy a house) there are programs like the home buyers plan and the lifelong learners plan.  To keep things (relatively) simple, I’ve ignored these.