With RRSP season in full swing, I’ve been receiving a few RRSP-related questions from readers on what they can do to maximize their tax savings.
If your marginal tax rate upon retirement is likely to be lower than your current marginal tax rate, it makes sense for most people to contribute as much as possible to an RRSP.
Related: RRSP Loans: Positives & Negatives
Tax Deferral of an RRSP
How you use your tax refund is another way to accelerate the growth of your investment account.
It’s important to note that an RRSP is a tax deferral and isn’t completely free of taxes. RRSP withdrawals are taxed in the year of the withdrawal, so the government gets their money later rather than sooner.
This is the biggest difference between a TFSA and an RRSP – RRSP is a deferral of taxes, whereas the TFSA is completely tax free (since it is used with after-tax dollars).
Any tax refund generated from an RRSP contribution needs to be used wisely to realize the full potential of an RRSP.
Using Your Tax Refund
How you use your tax refund depends on your own personal situation, but here’s a few ideas on how to use it (in order of priority):
- Consumer debt payments. Since consumer debt typically has the highest interest rates, it makes sense to pay this off immediately with a tax refund.
- TFSA contributions. For basic long term tax planning it’s a good idea to balance your money between a TFSA and an RRSP. Too much money in an RRSP means you could face a huge tax bill later on when you retire, and too much money in a TFSA means you may not be taking advantage of the tax savings (deferral) of the RRSP. If you have maxed out your RRSP, consider using the refund towards your TFSA.
- Emergency fund savings. In case you haven’t started one yet, an emergency fund is a good idea in the event something comes up and needs to be paid right away. Remember – it’s better to use cash for unexpected costs than to pay with a credit card (and carry a balance from month to month).
- Mortgage paydown. Since interest rates are so low right now, this takes a backseat to an RRSP or TFSA where you can usually get more for your money. However, if you are in the lucky position of having both maxed out, consider paying down your mortgage with your tax refund.
- RRSP contributions. If you’ve considered all the options above and still have money left over, consider putting it right back into your RRSP for the following year (assuming, of course, you have contribution room available).
Some people look at a tax refund (generated from an RRSP contribution) as ‘free money’. Not quite, and the government will get their tax dollars later on when the funds are withdrawn.
I’m sometimes tempted to use my tax refund on a vacation, but I usually end up buying something small like dinner & a movie and putting the rest into my TFSA.
Since an RRSP is a tax deferral, how much your RRSP is maximized depends on how you spend your tax refund. A tax refund spent on buying the latest consumer item is wasted and won’t help your RRSP (even if it’s more fun).
Conclusion: how you use your tax refund (generated by RRSP contributions) will determine how much your RRSP will grow. Money put towards paying off debt is never a bad idea and it’s important to find a balance between your TFSA and RRSP.
How do you plan on using your tax refund?