As personal tax season wraps up, I have identified what the most prevalent tax topic I have chatted with clients about over the past few months is. It has certainly been around RRSPs and more specifically alternatives to the RRSP, particularly for young families.
Most people understand the basic concept of RRSPs – make contributions to get a tax deduction now, reducing your taxes. As Canada has a marginal rate tax system (i.e., you pay more tax on each additional dollar earned within specified brackets), RRSPs save “higher rate” tax dollars. Most people don’t start withdrawing from RRSPs until retirement, when their income is expected to lower and thus their marginal tax rate is lower. In a nutshell, you are not only deferring the payment of taxes but also expect to pay tax on those funds at a lower rate.
While I am always happy to see people saving for their retirement, sometimes an RRSP contribution isn’t the best option. If you are in a lower tax bracket, especially temporarily as you are starting a business, spending more time at home as a caregiver for family or other reasons, but expect to earn more income, and thus be in a higher tax bracket, in the future, making an RRSP contribution now, is maybe not the best option from a tax perspective. I often recommend two alternatives: the TFSA or a spousal RRSP.
In my experience, the TFSA is one of the most underutilized savings tools. While you don’t get a tax deduction at the time of contribution, withdrawals from a TFSA are tax free (both your principal and any earnings). That’s right – you never pay tax on the interest or other investment income earned. Funds in a TFSA is also more accessible – they are not subject to withholding tax when withdrawn and you get any TFSA contribution room BACK the following calendar year. For those with lower income (especially temporarily with expected higher future earnings), TFSA contributions are an ideal investment option, preserving your RRSP contribution room for the future.
The spousal RRSP is another option that I find people are less aware of. This is a great option for couples where there is income disparity (i.e., one spouse is in a higher tax bracket and the other spouse is in a lower tax bracket – for instance, when one spouse is on parental leave, working less or not at all to be a caregiver). The spousal RRSP is set up in the name of the lower income spouse, with the higher income spouse making the contributions. The higher income spouse gets to deduct all the contributions into their own and the spousal RRSP accounts on their taxes, thus reducing their marginal tax rate. As such the household pays less tax overall. However, when funds are withdrawn from the spousal RRSP, it is taxed in the hands of the lower income spouse. This effectively provides for further income splitting in retirement – while we do have pension splitting provisions today, we may not have them in the future.
These are generic overviews and tax planning is a unique and specific process. Your accountant and/or financial advisor will work to ensure that a tax plan is customized for your circumstances but it’s important as a taxpayer to know and understand what is available to you.