categoryRRSP

How to Boost Your RRSP Contributions

Those who’ve read my article called Why I Will No Longer Contribute To My RRSP may raise an eyebrow at this article’s title. 😉

Please be aware that my RRSP game plan does not apply to everyone. For most people, maximizing their RRSP is a great idea.

So I wanted to share this tip to help optimize RRSP contributions for those who still have unused contributions.

Although I really don’t encourage going into debt, this method could require the use of an RRSP loan, a personal loan, a line of credit or any other form of borrowing. When done properly, it is possible to pay little or no interest while boosting your RRSP contributions.

So, if you contributed to your RRSP this year without reaching your maximum contribution, this article will probably be useful. 🙂

RRSP Season

That’s what many financial institutions like to call the first 60 days of the year. In fact, it is the last sprint to contribute to your RRSP to reduce taxes for the previous year.

Generally speaking, some people neglect their RRSPs all year round. Once RRSP season knocks at their door, these people rush to put money into their RRSP (sometimes with the help of a loan), to ensure they get a tax refund (in order to pay for the next trip down south).

Reminds you of someone you know? 😉

A much sounder way to save is to do it automatically and regularly throughout the year. This is an excellent financial habit to take to ensure a good retirement (early or not).

What’s more, once you’ve saved throughout the year, you’re in an excellent position to boost your contributions thanks to the RRSP loan, for example, which your financial institution may even have already offered you.

The Classic Method

I usually like to show you examples using my own numbers. However, as of today, my RRSP is already fully maxed out. I will therefore take my sister’s example to show you the classic method used to contribute to an RRSP.

In 2020, my sister contributed $11,780 to her RRSP. This will be used to reduce her taxes for the same year. Congratulations! I wonder who she takes after. 🙂 However, for the sake of a better understanding, I will round it up to $10,000.

She has about $12,000 left in unused contributions. So she could continue to contribute without any problem. However, she has decided to focus her savings in her TFSA, for now.

Using Wealthsimple’s calculator, I can get the details about her marginal tax rate and her estimated tax refund.

She can therefore expect a tax refund of approximately $3,270. Wonderful!

This is where good savers are already planning to reinvest this refund directly into their RRSPs to reduce their 2021 taxes. That’s exactly what my sister was planning to do.

This is where I came in. Because by using the RRSP loan, or any other form of borrowing, there is a way to boost RRSP contributions for the year 2020 without really paying more out of pocket.

The Optimized Method

If my sister got a loan for the same amount as the expected tax refund ($3,270), and contributed that amount within the first 60 days of 2021, she would then increase her total contributions to $13,270 in order to reduce her 2020 taxes.

As a result, her tax refund will no longer be $3,720. It will increase to $4,171.

With this amount, she’d have plenty of money to quickly repay the loan in full and avoid paying interest. There would even be enough left over to contribute to the RRSP again in order to reduce her 2021 taxes.

However, if you understood the method, you may see where I’m going with this.

If my sister can now expect to receive $4,171, then why not borrow that amount instead and add it into the RRSP within the first 60 days of 2021?

Her total contribution to reduce her 2020 taxes would then be $14,171, which would then generate a tax refund of $4,419.

You can keep going until you reach the point of intersection.

Ideally, one does not want to borrow more than the expected tax refunds, since it will be used to repay the loan. This way, you avoid paying interests. Of course, some RRSP loans have such low interest rates that it could still be interesting to borrow a little more and accept to pay some very minimal interests.

Ultimately, it’s up to you to decide how comfortable you are with borrowing to invest.

The Point of Intersection

In my sister’s example, the sweet spot is about $4,512 that she’d need to borrow.

Indeed, that means she’d contribute a total of $14,512 in her RRSP and get $4,512 in tax refunds. This refund would then be equal to the amount borrowed.

It could be simpler for you to use this calculator to find out the total contribution you would have to make. Simply enter the amount you have already contributed to date and your tax rate.

Upon receipt of the tax refund, my sister will repay the loan in full. She’d then be able to start fresh with regular (automated) RRSP contributions for 2021.

Finally, instead of a non-optimized tax refund of $3,700 to reduce her 2021 taxes, she will have added $4,512 to her contributions to reduce her 2020 taxes.

By doing so, she advances future contributions to her RRSP.  If she keeps doing that every year, she’ll max out her RRSP in no time and reap off the benefits of compound interest a bit earlier. 😉

A Debt That’s Worth Its Weight in Gold

Of course, the idea is to advance future contributions. It doesn’t necessarily have to be through an RRSP loan. The money can come from a line of credit or a loan from a friend, for example. You can be creative.

Personally, when I still had unused contributions, I borrowed the money from myself, or more specifically from my emergency fund. I had a zero-dollar emergency fund for a couple of weeks or months, but I was willing to take the risk. It also allowed me to pay no interest on a loan, besides the opportunity cost of the interest (1-2%) the money in my emergency fund would have generated.

If you are able to find interest-free money, it may be interesting to borrow more than the expected tax refunds. That’s entirely up to you. 🙂

In addition, for those who contribute to labour-sponsored funds such as FTQ or Fondaction, 30% or 35% tax credits increase tax refunds considerably and make the method even more efficient!

That’s precisely what I did back in 2018 and 2019, when I had not yet maxed out my RRSP. It really increased my savings and helped max out my RRSP sooner!

Keep in mind that you need to have the discipline to use the tax refund to pay off the loan in full, rather than using it to pay for an all-inclusive vacation. 😉

Bonus

Of course, anyone who optimizes their RRSP contributions will see their taxable income decrease. This could have the effect of giving access to or increasing GST and solidarity (or other provincial) tax credit refunds.

This is also a very interesting for families. By reducing their taxable income even further, parents who make use of this method will be able to increase their child benefits.

If these refunds and benefits are then added to the RRSP throughout the year, this will set the stage for the next RRSP season. At least, until the RRSP is maxed out. 🙂

Yes, More Tax Optimization

I’m really that boring. However, anyone who is able to use the method described in this article will benefit from it. 🙂

I’m curious to know if you have tricks like that to optimize your registered accounts or your taxes in general. Do you have any tips on how to make the most of RRSP season? Feel free to leave a comment!

In the meantime, I’m looking forward to my favourite season. I’m talking, of course… about tax season. 😉

Why I Will No Longer Contribute To My RRSP

I am one of the privileged few benefitting from an employer-sponsored pension plan. It is becoming increasingly rare these days. Generally, when we tell people we have a pension plan, we’re told how lucky we are.

In addition, there are different types of pension plans. One of them is the mother all of pension plans. I’m talking, of course, about the defined benefit (DB) pension plan. That’s the one offered by my current employer.

For many, it’s an excellent advantage. In my case, it’ll bring me closer to my goal much more quickly. On top of my contributions, my employer’s contributions will be returned to me in part when I resign, through the transfer of the commuted value.

For others, who are not aiming for FI and are not saving anything by themselves, it’s more of a gilded cage than anything else. At least, that’s how I saw it back in the days when I wasn’t saving. But that’s a whole other discussion!

How It Relates to the RRSP

First, the maximum RRSP contribution is the lesser of $27,230 (for 2020) or 18% of the previous year’s earned income.

However, a person with a DB pension plan will not be able to contribute up to 18% of their salary to an RRSP of their own. That wouldn’t be fair to those who don’t have a pension plan.

So, to balance it out, employers must calculate the pension adjustment (PA). This factor must then be deducted from the RRSP contributions.

For those interested (or for nerds like me), the calculation of a PA for a DB pension plan goes as follows:

(9 x annual accrued benefit) – $600

The annual accrued benefit varies from one pension plan to another. It is established as follows:

Pension formula * Annual salary

To give you an idea, I used my December 31, 2019, statement numbers. For your information, the Maximum Pensionable Earnings (MPE) for 2019 was $57,400. My annual accrued benefit is calculated like this:

[(1.5% up to MPE) + (2% above MPE)] * $61,442 = $942

Thus, my PA was calculated as follows:

(9 x $942) – 600 = $7,877

So while my RRSP contributions for 2020 should have been $11,382 (18% of my 2019 salary), my PA brought it down to only $3,505 ($11,382 – $7,877). Then, I could only contribute $3,505 to my own RRSP.

Long story short, the PA significantly reduces a person’s RRSP contribution room for the following year.

Why Stop Contributing?

Let’s keep in mind that I’ll reach FI once I have accumulated 25 times my annual expenses. In fact, I intend to reach this magic number once I take my pension’s commuted value. This amount can be transferred to a Locked-In Retirement Account (LIRA) up to the maximum transfer value (MTV) allowed by the Income Tax Act.

The MTV is calculated like this:

Annual pension at age 65 * Present value factor

The present value factor is based on age.

As an example, here are the important numbers from my December 31, 2019, statement :

  • Pension value: $14,100
  • Annual pension at age 65: $1,370

By applying the above-mentioned formula, I understand the MTV would have been $12,330 ($1,370 * 9). However, the pension value was $14,100. Therefore, if I had decided to resign on December 31, 2019, there would have been an MTV of $12,330 and an excess of $1,770 ($14,100 – $12,330).

What could I have done with that excess? Either cash it in and pay taxes on it, or transfer it to an RRSP.

However, transferring the excess to an RRSP can only be done when you have enough unused contributions.

Therein Lies the Problem

In order to reach FI, I will take the commuted value when I resign, at the latest, in 2026.

Being the nerd that I am, I have made various projections to estimate the value of my DB pension plan in 2026, as well as what the excess could be. Based on various hypothetical returns and projected salary raises between now and 2026, I estimate my excess could be somewhere between $26,000 and $44,000.

So, if I have no unused contributions left when I take the commuted value, I will have to cash in the entire amount and pay taxes accordingly. With no other income, this means between $4,500 and $10,600 in taxes for someone living in Quebec (according to this calculator).

Even worse: if I earned, let’s say, $60,000 that year before resigning, the excess will be added to my employment income. Worst-case scenario: I would have $104,000 of taxable income at the end of the year. That means I reach a higher tax bracket!

We want to avoid that, don’t we?

So, contrary to what I said in a previous article about maximizing all registered accounts as soon as possible, I must hold off on contributing to my RRSP until I resign. I have to save any unused contributions for later.

Also, let’s not forget that the PA significantly reduces my RRSP contributions each year.

Considering this, and the fact that my RRSP is currently maximized as of 2020, I estimate I’ll barely have $20,000 in unused contributions in 2026. Thus, there’s still a risk of not having enough unused contributions to absorb the entire excess.

To make up for this, I could resign at the end of the year and receive the excess at the beginning of the following year. In that next year, I would have no employment income. I would also have new RRSP contributions to add to the previous years. Finally, what wouldn’t fit in the RRSP could be used as income for my first year of early retirement. I would probably only make a partial withdrawal (less than 4%!) of my investments to make up the difference in that first year.

With a little luck, the amount would still be less than the basic personal amount and then, I wouldn’t have any taxes to pay. 🙂

Other Options

So if I can’t touch my RRSP until 2026, what do I do in the meantime?

I use the very wonderful TFSA until it’s maximized, of course. As of today, I still have about $45,000 left in unused contributions. We can assume an increase of about $6,000 in contributions a year. Maybe more, if we’re lucky!

If I keep saving $25,000 a year on average, I should be able to catch up on my TFSA contributions by early 2023.

Once that happens, I’ll need to start investing in a non-registered account. This type of account has no limit, unlike registered accounts. At that point, I would contribute the $6,000 (or more) per year to the TFSA and all the rest of my savings would go in a non-registered account.

Deferred Pension or Commuted Value Transfer

Some may wonder if it would not be better to just take the deferred pension and not bother with all the calculations I have just explained.

It depends.

If you’ve been contributing to your pension plan for a long time, then the commuted value, as well as the excess, could be really significant. For example, if you have $100,000 in excess and no unused RRSP contribution, the tax bill would be huge!

In this article, the author explains in detail his strategy. In his case, the commuted value was $290,143. He was surprised to learn that the MTV he could put in a LIRA was only $134,028. That means he had an excess of $156,115. More than half of his commuted value would be taxable, at a rather high marginal tax rate! In any situation, there is little chance that unused RRSP contributions could absorb all of this.

A person living in Quebec would have to pay $59,798 in taxes on such an amount. That reduces the real commuted value by a lot, doesn’t it? In the end, out of his $290,143 commuted value, he would really only get $230,345. That can make a big difference in terms of FIRE. Personally, I wouldn’t be willing to sacrifice close to $60,000!

You understand that it is therefore very wise to do your calculations before making any decision.

Furthermore, are you a good enough investor to “beat” the deferred pension provided by the plan, if you invest the commuted value yourself? And how many years do you have left before you can take the deferred pension?

These are many factors to consider. For my part, I much prefer to proceed as I have detailed, because that is what will allow me to reach my number much earlier. I made a plan to optimize everything and make sure I pay as little tax as possible. But for someone else, the reality could be completely different.

My Own Personal Experience

When I left my former employer in 2018, I was promised an annual pension of $3,314 at age 65. Nothing to write home about, right?

The other option was to transfer the commuted value of $42,000, of which $12,000 was in excess. Fortunately, I had plenty unused contributions at the time to absorb it all. So, the decision was easy to make. 🙂

Two years later, I am more than happy to have taken the commuted value to a LIRA and the excess to my RRSP. It has given a huge boost to my personal investments. It makes even more sense now that I am aiming for FI.

In fact, I’ve had an excellent return on my commuted value by investing it myself so far. Thanks to Passiv, I can give you an overview of my LIRA return since I opened the account two years ago.

So, the boring answer to the initial question is: it depends. It’s up to you to do your calculations.

The Importance of Planning

If I’d never bothered doing calculations, I’d have continued to maximize my RRSP every year until I resign.  The result could have been a tax bill up to $10,000. It would be even worse if I were to receive the excess the same year I resign, as it would be added to any income already earned. I would then reach a higher tax bracket and the tax bill would be even higher!

That’d mean less money in my pockets, more in the pockets of the taxman. By planning everything in advance, I make sure that I maximize the money I will keep from my commuted value.

It’s always ideal to get as close as possible to 100% of our money. In other words: pay as little tax as possible. This applies just as much to the 4% rule, which indicates to have 25 times your annual expenses. To be realistic, this amount must be net of any taxes. If you haven’t planned for (or optimized) this important aspect and you end up sending a third or your passive income to the taxman, you’re going to run out of money. So you have two options:

  • plan for a larger amount to cover taxes; or
  • optimize your taxes.

I know which one I prefer. As Pierre-Yves McSween puts it:

As much as we hate taxes when we build our wealth, we can benefit from tax rules once we have enough.

When you know how things works, you can make the most of it.

For the Lucky Few

This article was certainly aimed at a somewhat smaller audience, namely people benefiting from a DB pension plan. Even for them, it may not have been the most exciting article! There were a lot of calculations, formulas and complex terminology. On top of that, the terminology seems to differ from one pension plan to another! I hope I managed to be coherent, under the circumstances.

However, it did allow me to put together all the information I gathered on the subject and it helped me refine my strategy. I hope my thoughts on the subject helped some of you.

Have you ever had a DB pension? Have you ever had to choose between a deferred pension and a commuted value transfer? What did you choose? Or are you currently one of the lucky few? If so, what’s your game plan for when you leave the rat race?

Feel free to leave a comment! Seriously, I want to know. I’m that much of a nerd.