Thursday, January 19, 2012

Not All RRSP Contributions Are Equal

Ah, January, when thoughts turn to taxes.  I still do my own because my situation is pretty simple.  My yearly routine is to put on Ace Ventura Pet Detective and fill out forms for me and my wife.  Since switching away from paper forms a few years ago to the fabulous and free StudioTax I’ve been able to watch more of the movie.  StudioTax also has a special place in my heart because it’s written in .NET.  I’m guessing the name comes from the development tool .NET folks use, Visual Studio.

This post isn’t about StudioTax, though.  It’s about something I’m sure I’ve understood from newspapers and magazines turning out to be wrong: that your entire RRSP contribution results in a rebate equal to your highest tax rate.  This is the reason tax planners sometimes recommend not contributing to an RRSP until you are in a high tax bracket, like the last 2 federal ones.  You don’t want to waste getting about 40% back by contributing when you’ll only get about 32% back.  The advice is to set aside the money until you reach one of these brackets, just not in an RRSP.  These days that place would be a TFSA account.

It’s not so simple, though, as waiting until your total income moves you to a higher tax bracket and then plowing all of your savings into an RRSP account that year.

The Math

Disclaimer: I am not a tax planner, accountant or financial consultant. There are lots of other considerations than those below to make when deciding what’s right for your situation.  I’m just exploring something I came to realize recently, which applies to my situation.

The Canadian income tax system is what’s called progressive.  Not progressive in the “this is the better way” sense, but in the “progression from one level to another” sense.  Your entire income isn’t taxed at the same rate.  The first $x is taxed at a certain level, the next $y is taxed at a higher level, the next $z at an even higher level.  The feds have their own set of x, y, z values and rates, as does each province.  Except Alberta where there is no provincial income tax.

I’ll use small, hypothetical amounts for this discussion, and assume there are no automatic tax credits, as there are in the real tax system.

Let’s say the brackets and rates are:

Income Rate
First $50 15%
Next $50 25%

You make $60 a year.  That means you owe:

Income Tax Calculation Amount
On the first $50 $50 x 0.15 $7.50
On the next $10 $10 x 0.25 $2.50
  Total $10.00

Your employer would have taken this from your pay cheque, so you’ve already paid.  If you don’t do anything more to do with taxes you owe nothing and you’ll get nothing back.

Every dollar you contribute to an RRSP (or pension plan for that matter) lowers your taxable income by 1 dollar.  Let’s do the same calculation but with a contribution of $4.

Total Income $60
RRSP Contribution $4
Taxable income $60 – $4 = $56

Plug $56 into the tax calculation table and you get:

Income Tax Calculation Amount
On the first $50 $50 x 0.15 $7.50
On the next $6 $6 x 0.25 $1.50
  Total $9.00

You’ve paid $10 through your pay cheque, you owe $9, so you get a rebate of $1.  This is equal to your contribution times the higher rate, or $4 x 0.25 = $1.

However, if your contribution lowers your income into the next bracket down, the entire contribution is not worth 25%.  Only the portion that lowers your income to the edge of the higher bracket is worth the higher bracket’s rate.  The remaining portion’s rebate rate is the rate of the lower bracket.

To demonstrate, lets say you contribute $15 of your $60 income.

Total Income $60
RRSP Contribution $15
Taxable income $60 – $15 = $45

Now you owe:

Income Tax Calculation Amount
On the first $45 $45 x 0.15 $6.75
  Total $6.75

You’ve paid $10, you owe $6.75, so you’ll get a rebate of $3.25.  Note that this is not equal to your contribution of $15 times the higher rate, or $15 x 0.25 = $3.75.  This is because it’s a combination of the potion that brought your income down to $50 at the high rate, plus the remaining portion at the low rate.  That is:

Contribution Rebate Calculation Amount
Portion to get to $50 $10 x 0.25 $2.50
Remaining portion $5 x 0.15 $0.75
  Total $3.25


If you’ve been waiting to make contributions until you’re in a higher bracket, and you’ve finally reached that bracket, it’s not really worth contributing more than is enough to bring your income down into the next bracket.  In the example above, it’s not worth contributing more than $10 of the $15 to bring your income down to the lower rate.  Any more contributions will only earn a rebate of 15%.  You’re better to hold on to any other savings to use in future years in hopes that your income rises faster than inflation.

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