When shouldn't you buy an RRSP?

A lot of articles at this time of year encourage you to contribute to your Registered Retirement Savings Plan (RRSP). Indeed, the RRSP is one of the best tax planning strategies available to Canadians. But one critique of the RRSP is that even though you get a tax break when you put your money in, you have to pay tax when you pull your money out.

About 80% of the time, an RRSP makes sense. So what happens the other 20% of the time?

It is important to know your marginal tax rate when it comes to RRSP planning because the deduction you receive is based on your marginal tax rate. If you make $50,000 per year, you are in a 32% marginal tax bracket (Alberta plus federal rate). If you make a $1000 RRSP contribution, you will save $320 (32%). The higher the tax bracket, the bigger the tax savings. The lower the tax bracket, the lower the tax savings.

You also need to know your marginal tax rate when you take money out of an RRSP. In the same example, if your income is $50,000 and you take $1000 out of your RRSP, you will only get $680 because you will have to pay 32% in taxes.

What's the ideal scenario for an RRSP?

The ideal scenario is to put money into an RRSP when you are in a high marginal tax bracket (40%) and take it out when you are in a low marginal tax bracket (23%). In this example, you would be ahead by 17%. The worst scenerio is to put money in when you are in a low marginal tax bracket (23%) and take it out when you are in a high marginal tax bracket (40%). In this situation, you would be losing 17%.

When shouldn't you contribute to an RRSP?

If your income is low (about $10,000 per year) and you will not benefit from the tax deduction.

If you will be in a higher tax bracket in retirement. It's rare, but it happens.

Martha, for example, who owns her own business and spends next to nothing. She reports personal income of $33,000 per year. She has accumulated $750,000 in her RRSPs, $500,000 in investments and her business is worth at least $1,000,000. Her retirement income will be greater than $33,000, especially if she does not start spending some of her money. Martha should not contribute anymore to her RRSPs.

If you have too much money in your RRSPs. Some people have had such success with their RRSP investments that they shouldn't contribute any further.

For example, George saw his RRSP grow to more than $1.5 million, thanks to some well-timed investments in technology stocks.He now has a tax liability because he will have to pay tax on all the money earned. There is no point putting more into his RRSPs.

If you might soon be in a higher tax bracket, an RRSP contribution works as a tax deduction against your income. Any deduction saves you money in tax equal to whatever your marginal tax rate is.

Consider Betty, who earned $33,000 in 2004 but expects her income in 2005 will rise to $38,000 because she is working in a new job. The tax bracket cutoff (where you move from one bracket to another) is $35,000. If Betty claims a $1,000 contribution in 2004, the deduction will be worth 25%. If she waits until 2005 to claim the contribution, she will save 31% in taxes (because she is in a higher tax bracket).

It is just as important to be aware of the situations where an RRSP may not make sense as it is to be aware of when it does make sense.

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Jim Yih is author of Mutual Fundamentals and Seven Strategies to Guarantee Your Investments. He is the founder of CORE Financial Advisors and Account Representative of Manulife Securities International Ltd. Commissions. Jim can be reached through his Web sites Wealthweb.ca, Retirehappy.ca, COREFinancial.ca and JimYih.com.