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Discussion Starter #1
Q: "Should I make an RRSP contribution today, but delay claiming the tax deduction because I see myself in a higher tax bracket soon?".

I just did a web search on the topic. I found 18 articles all promoting the idea that this is a good idea. If they present any argument it boils down to (i) because a larger tax refund is better than a smaller one, and (ii) in the mean time your after-tax savings are growing with profits protected from tax. Only one site posts a warning flag without any specifics. On this forum as well as other Canadian financial forums, this belief that you benefit from a delay has now become received wisdom. Is it true?

Example:
You have $1,000 in after-tax savings. You are now in the 33% tax bracket but expect to be in the next at 39% in 5 years. Your investments earn 8%, (or 6.68% after-tax assuming profits are half-taxed). Do you ...

(a) Stash the cash in a taxable account for 5 years?
$1,000 is invested for 5 years at 6.68% after-tax.
That grows to $1,382

(b) Put the savings, plus the Contribution Credit into an RRSP normally?
$1,493 is put in an RRSP generating a tax reduction at 33% of $493.
That grows for 5 years at 8% to $2,193.
The withdrawal tax at 39% costs $855.
Leaving $1,338

(c) Put the savings into an RRSP but delay claiming the refund for 5 years?
$1,000 is put in an RRSP without claiming any refund..
That grows for 5 years at 8% to $1,469.
The withdrawal tax at 39% costs $573.
The tax refund for the original $1,000 contribution is claimed at 39% = $390.
Leaving $1,286

(d) Stash the cash in a TFSA for 5 years?
$1,000 is invested for 5 years at 8% after-tax.
That grows to $1,469

The decision will always favour using a TFSA, because it offers the tax-free-profits without any penalties from rising tax rates. So lets assume you have no extra TFSA contribution room. The choice is between (a), (b) and (c). In this example the choice to contribute to the RRSP but delay claiming the tax deduction (c) was the WORST outcome. The received wisdom was wrong.

The reason the advice is wrong is because it fails to acknowledge the existence of a penalty that grows with a growing time delay in claiming the deduction. This penalty essentially equals the profits that are NOT earned by the Contribution Credit that is NOT received because the tax deduction was NOT claimed. You can get an understanding of this penalty on the RRSP Nitty Gritty webpage and the 3rd video of this YouTube series. You probably have to read/watch from the top to understand it though.

You can input your own variable assumptions into a worksheet that models the (a), (b), (c) choices above. Use the 2nd tab. The decision choices are discussed at the Delay Claiming Tax Deduction section. The conclusions of that modelling show that that ...
  1. The RRSP-delayed-deduction choice is NEVER the best option.
  2. It may SOMETIMES be better than using an RRSP normally, but in all those situations using the Taxable account gives better outcomes than either.
  3. If you don't have the option to use a Taxable account for the interim, then consider those limited possibilities in (4).
  4. The RRSP-delayed-deduction choice is only better than using the RRSP normally when the higher tax rate is realized relatively quickly.
    .... If your income is within the Personal Exemption, then always delay claiming the deduction - which would pay you $0 anyway.
    .....If in the 22.5% tax bracket only delay a maximum of 6 years.
    .....If in the 33% or 39% tax bracket only delay a maximum of 3 years.
    This is because the penalty from the delay grows with time, while the penalty from moving up one tax bracket stays static.
 

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Your post is a little long so I didn't read it.

You have two questions here. Should you make an RRSP contribution and if you do, when should you take the deduction.

I would say that anytime your tax bracket goes into the 30% or more level, RRSPs start to become a pretty good idea. There are exceptions, but this is usually the case. If you are going to put the money in an RRSP, you might as well do it now as later, since you can shelter from tax, any gains on the investment immediately.

As for taking the deduction. Look at the new tax rate and look at the current tax rate and look at the difference in context to a rate of return. In other words if your current rate is 33% and next years rate is 39% then that is (39/33-1) an 18% increase. In other words, you will receive an 18% rate of return, by leaving your tax savings with CRA for one more year. If it takes two years to get into that tax bracket then you can divide that return by 2 (not precise but close enough) and see what you think of that. That is pretty much how the decision is made.

Others might have another opinion.
 

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As Optsy says, it's a pretty easy formula to figure out if it is worthwhile in your situation.

ROR= ((future rate/present rate)^(1/n years)) -1

If you think you can beat those returns then go for it and deduct now. But also, for comparison purposes I've heard some people saying that the phantom "return" gained by deducting later is "guaranteed". While that is true in the mathematical sense, in reality it is only as guaranteed as your income increase is...

Are you 100% positive that you will be making THAT much more money next year? Enough to get you substantially into the next tax bracket? Remember it's not enough to just barely hit the next bracket, you have to be substantially into it so that your full RRSP contribution will be deducted at that rate. Perhaps a no-brainer for those who take on a new high paying job or only worked for part of the previous year and will work full time this year (Graduated students who started working in the summer - hint hint). But for the wishful thinkers who are only hoping to perhaps be into the higher bracket next year you should consider that it is no guarantee, so don't treat your ROR as such...

If you are unsure I would err on the side of deduct sooner than later.
 

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Lots to work through & understand ... until then - bear in mind that the option b) & c) numbers are easy to misunderstand.
Option b) rolls the tax refund back into the RRSP, increasing the tax deduction. Option c) does not roll the tax refund into the RRSP ... so automatically, some of b)'s numbers are going to be higher.

Then too - this comparison is assuming the tax bracket will be the same at withdrawal, which may not be the case as YMMV.

Finally ... I'm not sure what the idea of "... or 6.68% after-tax assuming profits are half-taxed" is really a reasonable assumption. If the investment is interest, then 100% of the growth is taxed whereas if it's dividends, then the situation changes and if it's capital gains/RoC, it may be as much as 100% tax deferred until the investment is sold.


Cheers
 

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Discussion Starter #5
You have two questions here. Should you make an RRSP contribution and if you do, when should you take the deduction.... Anytime your tax bracket goes into the 30% or more level, RRSPs start to become a pretty good idea.
I don't understand why you feel it necessary to separate the two issues. By make the first decision without regard to the issues of the second, you lock yourself out of the optimal choice .... which is usually to use a Taxable account (assuming no room in a TFSA).

It's a pretty easy formula to figure out if it is worthwhile in your situation.
Again the optimal choice to use a Taxable account is simply ignored.

Option c) does not roll the tax refund into the RRSP ... so automatically, some of b)'s numbers are going to be higher.
In all four choices the ending wealth is calculated in after-tax dollars for valid comparison. The refund in option (c) is never received until the very end so it is correctly added into the other after-tax numbers. Nothing would be accomplished by first grossing up the equivalent amount that could be added to an RRSP, and then immediately deducting the withdrawal tax as it all comes out of the RRSP.

This comparison is assuming the tax bracket will be the same at withdrawal.
The tax rate used for the ending theoretical 'withdrawal' is the expected higher tax bracket assumed at the start. I believe Eclectic many be presuming that the time span considered here is the full term to retirement. No, It only looks at the time span until that higher tax bracket is reached. The ending wealth at that time will rank the best choice because no matter what is done from that time forward, the option with the greatest wealth will do better.

I'm not sure the idea of assuming profits are half-taxed is really a reasonable assumption.
The whole point of spreadsheets is that they allow you to input whatever variables you think reasonable. My choice seems reasonable to me. You are perfectly free to re-calculate cell C12 however you like.

For you, I changed the default assumption from half-taxed to fully taxed. Nothing much changed. When comparing the outcomes for an expected future tax bracket of 33%, the best option will still the Taxable account for delay less than 9 years, and a normal RRSP for delays greater that that. The RRSP-with-delayed-deduction was never optimal.
 

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I don't understand why you feel it necessary to separate the two issues. By make the first decision without regard to the issues of the second, you lock yourself out of the optimal choice .... which is usually to use a Taxable account (assuming no room in a TFSA).
It is two issues. The first issue is whether to make an RRSP contribution or not. In my simplified method, this pretty much depends on what rate of tax you can save with these contributions and from deferring tax on future returns.

Now if, and only if you decide to make an RRSP contribution, you will then need to decide what year to deduct the contribution on your tax return. This will depend on your current tax rate compared to a future tax rate.

The only time this is one issue is if you decide NOT to make an RRSP contribution. You can beat this to death with spreadsheats if you want but there is a 99.9% chance you will end up with the same conclusion. I would try to not over-complicate this, if you can. Anyway, those are my thoughts.
 

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I'm not so sure you've got this all figured out leslie. Your examples b) and c) used to show that a taxable account is better than RRSP are examples of wildly misusing an RRSP, or are just plain unrealistic.

What situation would an individual find himself where he deducts at a low rate and then a few short years later withdraws at a much higher rate? I can't think of any except some abnormal retirement situation. Similarly, making a contribution and then waiting a full 5 years to deduct is just reckless and not the proper use of an RRSP.

This math may be applicable to someone who is very close to retirement and trying to decide if they should contribute to an RRSP, I suppose. But in the context of the original question, it is certainly worth delaying the claim if you expect to jump up tax brackets shortly, as I described in my post above. Comparing b) to c) it is obvious that there is no need to delay the deduction 5 year if you return 8%. But you aren't guaranteed that 8% are you? The whole idea behind delaying the deduction is to get a high, (sort of) guaranteed return.

What is your situation and the context of your question and why have you chosen the specific examples provided in the OP?
 

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Discussion Starter #8 (Edited)
What situation would an individual find himself where he deducts at a low rate and then a few short years later withdraws at a much higher rate?
There is no situation I can think of. But that has no impact on the conclusions reached, or the validity of the model.

As I responded above ...."The model only looks at the time span until that higher tax bracket is reached. The ending wealth at that time will rank the best choice because no matter what is done from that time forward, the option with the greatest wealth will do better". "In all four choices the ending wealth is calculated in after-tax dollars for valid comparison." While no one who chose to use an RRSP normally would withdraw it soon after at a higher tax rate, the comparison must use either after-tax values or before-tax values in order to be comparable. An existing and ongoing RRSP has an after-tax value whether the funds are 'withdrawn' or not. I put the word 'withdraw' in quotes to indicate this is a valuation calculation, not a actual event.

If you must consider (b)'s withdrawal as an actual event, then think of it as if he withdraws the funds at the later year, get his wealth measured, and then re-contributes the same cash, leaving him exactly where he started. No wealth is gained or lost by the withdrawal.

Maybe you would find the model easier to understand if, instead of measuring all options in after-tax-dollars, you measure all options in before-tax dollars ... by the size of their RRSP assuming all their ending cash is contributed at that later date, if not already in one. Do the math yourself and you will see the the outcomes are exactly the same in ranking and in relative size.

Making a contribution and then waiting a full 5 years to deduct is just reckless and not the proper use of an RRSP.
On the site linked above there is a link to a list of 20 websites promoting the advice to delay claiming the deduction - without ANY warning of a time limit or the existence of the penalty for delay. Similarly on other Canadian Financial Forums, the advice to delay the deduction is common - without any warning. When analyzing choices why on earth would you prefer to ignore certain situations, instead of covering all the choices for all the variables? If you want to label the conclusion "reckless and improper" that is fine as long as the factual reality is presented for others to see.

it is certainly worth delaying the claim if you expect to jump up tax brackets shortly, as I described in my post above.
You have not provided any proof that your claim would result in better outcomes than using a Taxable account. Nor have you proved my math in error. You simply refuse the consider the option of using a Taxable account. The model I use is relevant to anyone facing an expected higher tax bracket in the foreseeable future. No one disputes that the future is unknown.

This model would apply to students taxed at 0%, as well as professionals at higher tax brackets who expect to go higher still, as well as people who receive a lumpsum inheritance that would put them in a lower tax bracket if all contributed at once, etc, etc, etc. It applies to anyone asking my original question ..." "Should I make an RRSP contribution today, but delay claiming the tax deduction because I see myself in a higher tax bracket soon?".
 

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... In all four choices the ending wealth is calculated in after-tax dollars for valid comparison. The refund in option (c) is never received until the very end so it is correctly added into the other after-tax numbers.
Valid as long as there is a withdrawal in year 5 at the high tax rate ... otherwise, a different situation may occur.


... The tax rate used for the ending theoretical 'withdrawal' is the expected higher tax bracket assumed at the start. I believe Eclectic many be presuming that the time span considered here is the full term to retirement. No, It only looks at the time span until that higher tax bracket is reached.
Which is locking the tax estimate at what may be an inaccurate rate, as most people I know are planning withdrawals for retirement where the withdrawal tax rate is going to be less for years. There are exceptions (especially for those here on CMF) but it is an important factor.


... The ending wealth at that time will rank the best choice because no matter what is done from that time forward, the option with the greatest wealth will do better.
I'll have to run some calculations ... it's not clear to me that the best choice driven by taxes at different time than withdrawal is taken will hold across different situations.


... The whole point of spreadsheets is that they allow you to input whatever variables you think reasonable. My choice seems reasonable to me.
Initially I was wondering what would have a favourable tax rate and would not have a future tax liability. Then I calculated an 8% savings account, where 100% of the interest is taxed at 33% where the after tax number is $1367.90, at the end of five years.

Maybe the disconnect is what "half taxed" applies to?


Cheers

PS

I'm out of time to check out future 33% withdrawal rate bit ... but I can't help wondering if there's a typo.
... the best option will still the Taxable account for delay less than 9 years ...
includes years one through three, which point four of the original post says under three years is fine.
 

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Hmm. My gut says something is wrong, but it appears your math makes sense comparing delayed deduction to taxable... I'll have to have a closer look. Thanks for bringing this up though! Quite interesting and it may change my plans as I'm precicely in the situation where I am asking the question "should I deduct now or later?"
 

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If you might be seeing a large severance payout in your industry you may want to save some room or you will pay a lot of income tax in the year you receive it. This would likely see you in your highest tax bracket as it would include your salary to date for the year plus your severance. Just one more thing to keep in mind-never entered into my thinking until I received one and had no unused RRSP room left.
 

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I realize that this is an old thread but I think I have found a flaw with the OP's first post... In option c, the original contribution should be $1640 of which $640 will be claimed back as a tax deduction in year 5. After compounding $1640 @ 8% for 5 years, the total becomes $2409. Reduce this by the $640 and you are left with $1769. This makes option c the best overall choice. The only valid comparison to an "after tax" TFSA contribution is a "pre tax" RRSP contribution.
 

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Ok. Here is what I get for results...

Option (a) Invested in Taxable Account... Invest $1000 after tax for 5 yrs @ 8%...Taxed at 33% for first 4 yrs, 39% in yr 5. $1469 less taxes of $161 nets to $1308

(b) RRSP-Claim deduction first yr.... Invest $1000 + expected refund @33% tax of $493 for total starting amount of $1493. Compound at 8% for 5 yrs equals $2193 with a tax liability in year 5 of $855. Net amount...$1388

(c) RRSP-Claim deduction yr 5.....Invest $1000 + expected refund @39% tax of $639 in yr 5, for total starting amount of $1639. Compound at 8% for 5 yrs equals $2409 with an ending tax liability of $939. Nets to ...$1469

(d) TFSA ....... Invest $1000 compounded @8% for 5 yrs...Nets to .............$1469

This does not factor in inflation or the time value of money.
 

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You are taxing the unregistered account (a) at 33% gaspr. In reality it would be around 50% of that with capital gains and dividends. Unless you are assuming you're getting 8% in interest income somehow...

In (c) you are incorrectly compounding the tax return 39% for 5 years, but you can't do that because you do not get the refund until year 5...

The essence of this gambit is that: Without the benefit of the tax refund, the growth of the RRSP funds after tax is less than the growth of the funds invested in an unregistered account after tax. At year 5 all things are made equal (ie. the money is transferred to the RRSP and deducted), so the lower after tax growth of the RRSP from year 0-5 is what is causing the favorable benefit of the un-registered vs RRSP.

As you can see above, I was also very skeptical of this originally, but I believe it is correct and the math does work.
 

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In (a) I assumed the investment was in a GIC etc so taxed on interest income so I believe I did this correctly. I also believe that I did (c) correctly. (c) should be the same as (b) except that since the deduction is made in year 5 (which is taxed at a higher rate as per the OP), the initial amount should be adjusted accordingly. I think what is throwing you off is the tax refund. To me, it makes perfect sense that (c) and (d) work out to exactly the same amount. Post tax TFSA contributions have to be compared to the equivalent pre tax RRSP amounts. The refund is not relevant...only when the deduction is made.
 

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From what I figured out the only time one would think about a delayed deduction is when you'll have a significant rise in income the following year. Now the income gain must be large enough to boost your normal tax bracket rate to a value greater than your average yearly return on your investments and remember to calculate the amounts differently if it drop down to different brackets within the deduction amount.

On a side note, the return on the "refund amount" you didn't get this year will be at the mercy of your investment returns. So if you delayed and your investments go up significantly you've lost the gain on it. Of course if the investments go down, you've gained more.

In the real world I think this strategy only applies to a small percentage of people, like those that know a big bonus is coming next year. Some commission sales people I know fall into this category where they'll get 3 years of normal income and the forth year they'll get a big spike upwards in pay bumping them 2+ tax brackets.
 

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In (a) I assumed the investment was in a GIC etc so taxed on interest income so I believe I did this correctly. I also believe that I did (c) correctly. (c) should be the same as (b) except that since the deduction is made in year 5 (which is taxed at a higher rate as per the OP), the initial amount should be adjusted accordingly. I think what is throwing you off is the tax refund. To me, it makes perfect sense that (c) and (d) work out to exactly the same amount. Post tax TFSA contributions have to be compared to the equivalent pre tax RRSP amounts. The refund is not relevant...only when the deduction is made.
I don't understand what you mean by this. The initial amount is $1000. With no deduction applied there is no growth, yet you show 5 years of growth on a refund that wasn't received. "$1639. Compound at 8% for 5 yrs equals $2409"

Also, the whole point of this is that the tax rate applied in an un-registered account is significantly less than the marginal rate. Of course if you assume it's a GIC you aren't going to see the benefit (An 8% GIC?? Nice!)

It's alrite, this is a tricky one... Took me multiple tries to figure it out. Leslie can be extremely confusing to read, too (sorry man).

What I wrote above: "Without the benefit of the tax refund, the growth of the RRSP funds after tax is less than the growth of the funds invested in an unregistered account after tax." is the key to understanding the mechanism going on here.
 

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Cainvest - the jump doesn't have to be super significant though, particularly in this low interest rate environment. Moving only one tax bracket in a year gives you somewhere between a 3% and 15% guaranteed return (depending on income and province).

For those of us with DB and forced pension contributions that lower our RRSP room significantly, it is wise to keep a close eyes on the tax brackets to make the very most of our precious few RRSP dollars.
 
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