Which do you do? Maximize or Optimize your RRSP
As the RRSP deadline approaches (before March 1, 2011 by the way), many look into maximizing their RRSP contribution for the year. Personally, I like to optimize my RRSP contribution. The distinction may be small but there is a difference. Not everything is about tax refund …
Optimizing RRSP Contribution
Optimizing your RRSP refers to the process where you borrow enough money to invest in your RRSP so that the income tax refund you get covers the loan. It’s azero sum process (except for the interest possibly). Here is an example to explain the process.
I’ll use some simple numbers for easy math. Assume you have the following:
- $8,000 RRSP Contribution for 2010
- 30% marginal tax rate
Your RRSP contribution and marginal tax rate would allow you to borrow $3,425 to optimize your RRSP with. Your total contribution would be $11,425 for the year. With a 30% marginal tax rate, your refund would be $3,427.
I have kept the math simple but if in the process of contributing to your RRSP, your income tax bracket was to go down, you need to take that into account in your calculation. If you don’t want to calculate it on your own, many of the tax software out there offer some tools to calculate your optimized contribution for you. It’s pretty simple to calculate though. Every extra contribution, provides you with a 30% refund (replace 30% with your marginal tax rate). You just need to calculate until your refund is $0.
- $8,000 @ 30% = $2,400 refund
- $2,400 @ 30% = $720 refund
- $720 @ 30% = $216 refund
- $216 @ 30% = $65 refund
- $65 @ 30% = $19 refund
- $19 @ 30% = $5 refund
- $5 and I stopped here with essentially $3,425 in refund.
In the event that you have a defined contribution plan with your taxes adjusted at source, the process is much more difficult to apply since your taxes are essentially refunded as part of your pay. Your company payroll would take your RRSP contribution into account for your income tax calculation.
Maximizing RRSP Contribution
Maximizing your RRSP usually means that you contribute the maximum your contribution room allows for the year (and if you can, the past years). For many, it’s not always easy to max out the yearly contribution. I know I have not been able to from year to year.
If you participate in a regular contribution plan, maximizing your RRSP Contribution may be as simple as topping it up at the end of the year. To understand your maximum contribution, you need to calculate it based on your previous year’s income. The maximum your are allowed for 2010 is $22,000. You should already know it from your 2009 notice but here is the simple calculation:
2009 Income Reported X 18% = RRSP Contribution Room to a maximum of $22,000. Your overall contribution room may be larger as the unused amount from past years accumulates from year to year. Your notice should provide you with that information.
If you have a registered pension plan (RPP) or a deferred profit sharing plan (DPSP), you need to deduct it from the total above. For example, if your contribution room is $10,000 and your DPSP contributed $2,500, your contribution room is now $7,500.
Maximizing RRSP contribution is actually challenging as it requires significant savings. 18% of your gross salary is quite a bit of money to put aside. It’s important to not let it bother you as you need to start early to reap the rewards down the road. With the arrival of the TFSA, if you are in a lower tax bracket, the TFSA may be better to top up first. Later in life when your income tax is higher, you could always move your TFSA in your RRSP but at that point, both are growing tax free. You’ll need to consider how it all fits in your retirement plan.
A recent article in the Financial Post caught my attention regarding maximizing your RRSP. It’s a very good article that I recommend you read as it compares RRSP vs TFSA contributions. I personally do TFSA first now.
Readers: Do you optimize or maximize?
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