RRSP 103: How Much Should I Contribute to My RRSP?

Key Takeaways

• Understanding individual marginal tax rates is crucial in determining the optimal amount for RRSP contributions.
• The tax brackets and rates at the time of contributing RRSPs significantly impact the amount of tax refund received.
• Considering future changes and various factors is essential in crafting the most advantageous plan.

Expanding on the foundation of RRSP basics (RRSP 101) and available contribution room (RRSP 102), this article delves into the intricacies of selecting the optimal contribution amount within this room to attain maximum tax advantages. Before delving into this, we need to understand Canada’s progressive tax system and its impact on personal income tax.

Progressive System

In Canada, we employ a progressive tax system characterized by distinct tax brackets. The CRA divides an individual’s income into several brackets, each subject to taxation at its corresponding rate. As income increases, the applicable tax rate also rises.

People often believe that as long as they earn one dollar less than the starting amount of a new tax bracket, they can save a significant amount of taxes. This notion is incorrect. Because Canada employs a progressive tax system, earning slightly more or less around the tax bracket threshold has a very limited impact on the total tax payable. Therefore, when calculating personal income tax, we cannot simply multiply the total income by the marginal tax rate. Instead, we should multiply the income within each tax bracket by its corresponding tax rate and then sum the results to calculate the total tax.

To better illustrate this concept, consider the following example:

Example:

Question: Assuming a 2023 income of $60,000, without factoring in other tax obligations, deductions, or credits, what is the owed tax amount?

Answer: The tax payable is $12,837, calculated as follows:

Tax Bracket 1: $49,231 × 20.05% = $9,871
Tax Bracket 2: ($53,359 – $49,231) × 24.15% = $997
Tax Bracket 3: ($60,000 – $53,359) × 29.65% = $1,969

Total Tax: $9,871 + $997 + $1,969 = $12,837

Table 1: Marginal Tax Rates for Ontario Residents in 2023 (Combined Federal and Provincial Rates)

After understanding how to calculate personal income tax, we can now calculate the value of the RRSP.

The Value of an RRSP

In RRSP 101, we discussed the primary advantage of RRSPs: the tax deferral – RRSP contributions are not taxed in the contribution year but are deferred until withdrawal. Since everyone has different marginal tax rates, the tax savings from contributing to RRSPs can vary. For instance, assuming a marginal tax rate of 53.53%, contributing $10,000 to RRSPs in this tax bracket can result in savings of up to $5,353 in taxes. In contrast, with a marginal tax rate of 20.05%, the maximum tax savings for the same RRSP contribution would be $2,005. Therefore, investing $10,000 in RRSPs yields significantly different tax savings based on individual tax brackets.

How to Choose the Optimal Contribution Amount?

Through the following steps, we can estimate the optimal contribution amount to RRSPs:

1. Start by checking your maximum available contribution room. This is the maximum amount you can contribute to your RRSP.
2. Estimate your marginal tax rate based on your income by referring to the provided tax rate table.
3. Within the maximum available contribution room, consider contributing enough RRSPs to reduce your income to the starting point of the current highest marginal tax rate.
4. If you still have contribution room, you may consider contributing additional RRSPs to further reduce your income to the starting point of the next tax bracket. Repeat this process until satisfied.
5. Sum the contributions from steps 3 and 4 to determine the total RRSP contribution for the year.

Additionally, please keep in mind the following factors:

• If you anticipate a significant increase in future income, you may consider delaying RRSP contributions for the current year and reserve the contribution room for later use.
• If your current marginal tax rate is already at the lowest bracket of 20.05%, you may also consider saving RRSP contribution room for the future. Contributing at the lowest tax rate might not fully leverage the tax deferral feature unless you plan to use the Home Buyers’ Plan (HBP) or Lifelong Learning Plan (LLP) in the near future, or if you anticipate having a sufficient Personal Basic Amount or other tax credits to offset the taxes payable upon RRSP withdrawal in the future.
• If further income reduction is needed to meet other government benefit requirements, you may consider contributing additional RRSPs to achieve this.

Example:

Suppose your income in 2023 is $60,000, with $10,000 available RRSP contribution room. How should you contribute RRSPs to maximize benefits?

We present two scenarios for your consideration:

Scenario 1: Contribute $10,000 in RRSPs in 2023, utilizing all available room.

With this scenario, you can potentially save up to $2,780 in personal income tax for the contribution year.

($60,000 – $53,359) X 29.65% = $1,969
[$10,000 – ($60,000 – $53,359)] X 24.15% = $811

$1,969 + $811 = $2,780

Scenario 2: Contribute only $6,641 in RRSPs in 2023, leaving $3,359 for 2024.

With this scenario, you can potentially save up to $2,965 in personal income tax over two years.

2023: ($60,000 – $53,359) X 29.65% = $1,969
2024: [$10,000 – ($60,000 – $53,359)] X 29.65% = $996

$1,969 + $996 = $2,965

According to the above calculations, Scenario 2 could potentially save $185 more in taxes compared to Scenario 1,seemingly making it a better choice. However, it’s important to note that these calculations assume no changes in future income or tax rates in 2024 (ceteris paribus). If you anticipate a significant decrease in your income in the coming year or expect substantial tax cuts by the government, Scenario 1 might be the better choice. Therefore, when calculating RRSP contribution amounts, it’s essential to consider various factors for a comprehensive decision-making process.

In conclusion, this article explores how to choose the optimal RRSP contribution amount based on Canada’s progressive tax system. Understanding one’s marginal tax rate, anticipating future changes, and implementing effective strategies can optimize the benefits of an RRSP.

In the next article (RRSP 104), we will delve further into selecting financial products based on risk tolerance and maximizing contributions through RRSP loans (RRSP 201).

For more RRSP-related articles, please visit our RRSP Registered Retirement Savings Plan Guide.

Last Updated: January 28, 2024
Published Date: February 19, 2020

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