Maximizing your RRSP is not always the best financial advice

As opposition to what your bank advisor may say, it is not always the best advice to maximize your RRSP every year.

In order to make good RRSP decision you have to understand the math behind. First there are two things:

1-Effective Tax Rate

2-Marginal Tax Rate

The Effective Taxe Rate is the percentage of taxes that you pay globally. The Marginal Tax Rate is more complicated but also more interesting. Basically, not all dollar earn are imposed at the same rate. Each year the governement (Federal and Provincial) publish the various bracket and rate for the Marignal Tax Rate. The graphic bellow indicate the marginal tax rate in function of the year and the income. The exact number were simplified to facilitate reading.

Let's suppose John usually earn arround ~50k$/year and take a few RRSP each year, but he still has extra RRSP space. In 2011 he wins lotery, so his financial advisor tell him he should full his RRSP which would maximize his return by having a taxable income of only ~30k$. That was probably a bad idea because that made him change his imposition rate.

Lets suppose in our example there was an exceeding ~8000$ below the 35-40% bracket. That mean this 8000$ saved only 25-30% instead of 35-40%in tax return. That is a 10% difference or 800$! If John would have amortissed his RRSP investissements he could have been roundly ~800$ richer.

Some people may argue that RRSP interests are not taxable and that he had his tax return earlier so he could invest it earlier hence earning more interest. This is sometime true, so we have to do the maths. Lets suppose he is able to get a 6% interest rate (We assume the same interest rate for both RRSP and unregistered placements). We obtain the following scenario:

That is 554$ more money in his pocket in 2012! In order to have the same amount of money in 2012, John would need to have an interest rate of 19.512% which would be fairly unrealistic in those days. At 50k$/year, 554$ is relatively close to 1 week of net salary for John, so John can take a week off for free!

In addition to that, RRSP are more advantageous if you are able to get them at a higher tax rate than the one you will pay at retirement. The Color plot with an overlay of you salary can help to predict your earning growing versus the gouvernement marginal tax rate evolution.

I hope you enjoy!

Max