It seems like an obvious move as tax season begins: contribute to your registered retirement savings plan (RRSP) and reap the rewards of a larger tax return. Right?
Not necessarily. It’s a misconception that William Chan, a certified financial planner and principal of Modern Vision Planning, says is fairly common.
“Sometimes people’s deposits are for amounts that aren’t necessarily beneficial for them, because they don’t take into account the tax implications of what they’re doing, there’s just this concept of RRSPs and refunds,” Mr. Chan said.
If you’re not already familiar, RRSPs are tax-sheltered investment accounts, and one of their incentives is that the money you invest is deducted from your income taxes, which can lead to extra money in your tax refund. Your investments are also sheltered from capital gains taxes as they grow, but you’ll eventually pay income tax when you withdraw money from the account in retirement.
That’s different from accounts such as the tax-free savings account (TFSA), where there’s no upfront tax benefit, but you’ll also be untaxed on both capital gains and any withdrawals in the future.
There have always been arguments to be made for certain subsets of the population to prioritize one of either accounts, and things are further complicated now with the introduction of the First Home Savings Account (FHSA), a powerful new tool that combines the income tax benefits of RRSPs and the complete shelter from withdrawal and gains taxes of TFSAs.
We’ll parse through some arguments against contributing to an RRSP for certain parts of the population. In particular, younger or lower-income investors likely have many alternatives they should consider first.
1. If you don’t already have an emergency fund or other investments that are liquid
One of the biggest downsides of the RRSP is that the money is difficult to access until retirement. Earlier withdrawals can lead to tax penalties and a loss of your RRSP contribution room (there are some exceptions, such as withdrawing some money for a home purchase).
Scheherazade Hasan, a senior adviser at Wealthsimple, said you should ensure that you have funds that could cover at least three to six months of living costs saved in an account that isn’t linked to the stock market at all – ideally in a high-interest savings account.
Even after that, it could be a good idea to have some investments in a TFSA first – or an FHSA if you plan to buy a home – especially if you foresee having to take out money in the near future for a large expense.
2. If you make roughly $100,000 or less
Ms. Hasan says anyone making under $50,000 should focus on their TFSA or FHSA, since the tax deferral benefits for the RRSP are quite small if you’re in a lower income tax bracket. Plus, the TFSA has the added benefit of its flexibility and the lack of any taxation upon withdrawal, which could be extra beneficial if your investments have many decades to grow exponentially.
Even for people approaching around $100,000 of income in a year, the decision isn’t necessarily clear cut. If you expect your income to grow into higher tax brackets as you progress in your career, Ms. Hasan says it could be worth saving your RRSP contribution room for future years, when larger contributions could save you further money by lowering your tax bracket.
The same is true if you expect a windfall down the road. Since your RRSP contribution room carries forward, it could shelter you from a large tax bill if you were to sell an investment property or receive a large inheritance.
3. If you plan to just spend the extra money from your RRSP refund
In a way, Mr. Chan says you aren’t necessarily saving on income tax with the RRSP. You’re just delaying your taxation until retirement, since your withdrawals will be taxed as income.
That’s why it’s important to use your tax refund smartly. For example, using the money to invest in a TFSA is one of the best ways to capitalize on your return, especially if you’re young and have a long investment horizon.
But if you plan to use your tax refund on an unnecessary purchase, you’re probably not making the best financial decision.
“Ask yourself, do you need that refund ... because if not, you’re just kicking the can down the road,” said Mr. Chan.
4. If you have unpaid debt
This one may seem obvious in today’s interest environment, but paying debt off first wasn’t always the right move when rates were low and investments could outperform the cost of servicing debt.
Today, Mr. Chan says your priority should be to pay down any debt you’re carrying, especially higher-interest loans like credit cards or even your balance on a line of credit.
5. If you have children and could qualify for extra RESP grants
The Registered Education Savings Plan is one of the best tools for Canadians to invest for their children’s postsecondary education. Capital gains are untaxed, and the government matches 20 per cent of your contributions per year, up to a maximum of $500.
But households under different thresholds of income can qualify for various extra grants from both provincial and federal governments just for taking part in the program. Mr. Chan says it can make for a better value proposition for parents who want to ensure that their children can afford to study.
There’s another bonus: Once your kids are in university or college, the money is actually fairly liquid. If it turns out there is excess unneeded money because of scholarships or other factors, your own contributions can be taken out and used as long as your child is in school.
6. If you have a robust workplace pension, especially a defined benefit pension plan
One of the key caveats around the RRSP is that withdrawals will count as income and be taxed as such when you retire. Pensions also count as income, so relying on both an RRSP and a pension in old age could put you at risk of being placed in a higher tax bracket and paying more than necessary.
For that reason, maxing out your TFSA first may be a better option if you’re confident you’ll have a good pension to rely on, since those withdrawals are completely untaxed.
Mr. Chan adds that defined benefit pension plans are a particularly robust and reliable form of retirement income. If your workplace offers one, it might be even more reason to max out your other investment vehicles before contributing to an RRSP.
7. If you plan to buy a home
The FHSA, which was introduced in 2023, is a very powerful investment tool. Your contributions are deducted from taxes the same as an RRSP, and your withdrawals are untaxed like a TFSA.
Another benefit is that if you end up not buying a home, the money can be rolled into an RRSP without affecting your RRSP’s contribution room. So there’s little reason not to max your FHSA first if there’s some chance of you buying a home.
There are just two things to keep in mind. The first is that an FHSA can only be open for a maximum of 15 years before it must be closed. If it’s very likely that it’ll take longer than 15 years for you to purchase a home, it could be a reason for pause.
And lastly, the deadline to receive income tax refunds based on FHSA contributions is not the same as the RRSP. The deadline for the FHSA was Dec. 31, meaning that you won’t get a refund this year for contributions you make now. But you will get them next year, and that’s still enough reason for advisers to recommend FHSA contributions first.
Are you a young Canadian with money on your mind? To set yourself up for success and steer clear of costly mistakes, listen to our award-winning Stress Test podcast.
Editor’s note: An earlier version of this article misstated when individuals can access funds in their RRSP, and the penalties for early withdrawal. This version has been updated.
Salmaan Farooqui