Annual Rant Re: RRSP Season...

For those who follow my writings, you won't be surprised that I, once again, have an article to bemoan the Canadian phenomenon of "RRSP Season" that is starting this week and will reach its feverish crescendo by March 1, 2024.

Why such bitterness at what, on the surface, seems like a good thing if not well-thought financial planning?

The answer is multi-layered: (1) Canadians who have been procrastinating in saving for retirement are suddenly reminded by large (and small) financial institutions that there is only 60 or so days left to get their 2023 tax deduction via an RRSP contribution. On the surface, we are reminding folks that it is never too late to save and that a tax deduction usually implies receipt of a tax refund cheque at tax time. How can that possibly be wrong?

Firstly, last minute contributions driven by pure tax considerations is no way to plan for retirement. Two wrongs don't make a right, and slapping money in an RRSP at the last minute when an entire year of tax-deferred growth has been missed isn't the surest way to grow one's retirement nest egg.

Secondly, the act of contributing to the RRSP does not always mean claiming a deduction for the year that ended. The laws do allow a person contributing to an RRSP to only claim a deduction at a later date, perhaps in a year when the individual is facing a higher tax bracket, and where the value of the tax refund could be substantially higher.

Thirdly, once the cash is contributed, the tough part is to invest this cash and not leave it in liquid form (the "mattress" approach) especially in light of rampant inflation. But if the person has poor financial advice or assistance while a tax refund provides 'instant gratification' the lackluster returns generated by having selected the wrong type of investment will end up being counter productive. One interesting use of any tax refund might be, for example, contributing it to a Tax Free Savings Account.

(2) The rush to the RRSP as the "default" solution for retirement savings is often suboptimal for many Canadians, especially business owners that own their own companies. Why use a solution like the RRSP capped at its single annual contribution limit (roughly $30,000) when the same individual who has a business could triple if not quadruple those tax deductions by using a registered pension plan instead ? The well-known Individual Pension Plan (since 1991) or its upgraded version, the Personal Pension Plan (since 2011) come to mind.

To get a sense of what a business client can do with a Personal Pension Plan visit, for example, the Industrial Alliance microsite dedicated to this product: ppp.ia.ca/en

(3) Incomplete understanding of tax laws as they operate in the context of registered accounts often lead many to make honest mistakes. For example, the fallacy of the "RRSP tax refund" comes to mind. Let me explain.

Over the years a number of individuals (some of them highly educated doctors and lawyers) have argued with me that - in their opinion - one should prefer the RRSP over a Pension Plan because individuals are taxed at higher tax brackets than corporations and therefore, a dollar contributed to an RRSP provides a higher 'tax refund' than a dollar contributed by a corporation to a pension plan. Since more "refund money" is better than less, ergo, when deciding between using the RRSP or a pension plan, the RRSP is the better option.

This is a classic case of "back of the envelope" short-cut logic that simply fails upon careful examination of the way the Income Tax Act (Canada) works. To demonstrate this, one must use a numerical example.

Let's imagine that a business owner has a company that generates about $500,000 of taxable corporate income. The owner only needs an after-tax "take home" pay of $107,296 to buy gas, groceries, coffee etc. Given personal tax rates, the gross salary before personal taxes are paid must therefore be $150,000 (minus personal taxes of $38,944 yield a net income of $107,296). Any savings that the individual business owner wishes to accomplish will be done by having the corporation contribute directly into the pension plan (for ease of math, let's assume total savings are set at $30,780).

Now, the other business owner is convinced that an RRSP tax refund is better so shuns the pension plan solution and wants to contribute $30,780 to an RRSP instead. Since contributions to RRSPs come from personal sources, his pre-tax salary of $150,000 must now be grossed up by $30,780 (the value of the proposed RRSP contribution) for a total salary of $180,780. One issue that we won't even compute is that this may, depending on the province, generate additional payroll taxes - since we have a higher salary to deal with.

Bottom-line, the RRSP saver ends up with $30,780 in the RRSP, and 'take home' after-tax income of $107,296. In both cases, the Corporation deducted the same dollars and the corporation is in the same tax position, namely $180,780.

The inexorable conclusion is that there is ZERO absolute advantage of having used an RRSP with its 'personal tax' refund over a pension plan. Yet, at first blush, the logic of using the RRSP seemed irresistible.

(4) Finally, for those who aren't business owner, a Tax Free Savings Account might actually be a better option than the RRSP under a number of circumstances. While we won't expand on those circumstances here, it is generally accepted that receiving tax free income for those in very high tax brackets in retirement does provide an edge especially since RRSP/RRIF income is considered 'ordinary income' during the decumulation phase.

Therefore, again this year, my advice to Canadians is, "don't be a sheep" and blindly run to your financial institution to get your RRSP contribution in before the end of February without first having a chat with a professional financial planner (preferably an impartial one that won't make a commission when you contribute to the RRSP) as to whether that is indeed the smartest move to make.

You work hard for your money, and your money needs to work hard for you in return. If you place it in the wrong savings vehicle (or misuse it) because of ignorance of the law, you'll find that most people will have little sympathy for you.

Happy New Year!!