I’ve often heard the suggestion that if you are expecting to get a raise in the near future, make your RRSP contributions now, but wait until you are in that higher tax bracket to make that RRSP deduction. You’ll find this advice in many sources.
Is hoarding the generated deductions until you can make the most use of them, ie. when you are in the highest tax bracket a beneficial strategy? Let’s analyze the two cases:
- If I use the RRSP tax deduction now, I can take the tax refund I receive in April and invest it now, rather than later.
Let’s say my marginal tax rate is T1. So making an RRSP deduction of R now will generate an RT1 tax credit in April. Let’s say that I am planning on getting a raise, or changing to a new, higher-paying career n years from now. Let’s assume I can reinvest my tax rebate and earn an annual rate of return of i. So in n years, my tax rebate will have grown to R(T1)(1+i)n.
- If I instead use the RRSP tax deduction later, when I am in a higher tax bracket of T2, I will get a larger tax refund, but I will have lost out on any earnings my money might have made in 1). My tax refund will be RT2.
So, it makes sense to take that RRSP deduction if T1(1+i)n > T2. It doesn’t look so complicated after all. Let’s plug in some numbers. Let’s say that you’re currently in a 31% tax bracket, and are expecting to move into the 38% tax bracket in the future. Let’s also assume that i=7%. Solving for n, we get n > 3. So if you are expecting a raise more than 3 years in the future, it makes sense to make that RRSP deduction now. And a smaller change from the 31% tax bracket to the 34% tax bracket yields n > 1.4. You can also fix your time n and solve for the new tax bracket T2.
Since raises are hard to predict with certainty, delaying RRSP deductions will most likely only make sense for people who are moving up several tax brackets (ie. those going to school earning summer/co-op income while making RRSP contributions and transitioning to full-time careers). Although even in this case, because it is not possible to predict the future, I would take the tax rebate now rather than later.
It is important to realize the difference between contributions and deductions. There is no reason why you shouldn’t make those contributions as soon as possible. I’ve heard people telling me before, to not put money into RRSPs until you are older and “until you have taxable income are able to make use of them.” This is utter nonsense and comes from the confusion between contributions and deductions. Most working adults make their contributions and deduct the full amount on their next tax return, so contributions, to them, are one and the same. But in general, they aren’t.
Make your contributions as early as you want (as soon as you have the room) so it can grow inside the RRSP without having to pay tax on any dividends or capital gains you might generate when you buy & sell. Use your deductions later on, as soon as you have taxable income, or later, if you plan on getting a raise (check to see if it’s worthwhile using the formula above).