Retirement Account – Taxation
Many folks should use tax deferred programs such as the RRSP or 401(k). Contributions made into a retirement account is tax-deductible and can grow tax-free in the account. When it is eventually withdrawn and taxed the plan holder will likely be in a lower income tax bracket. I would personally try to keep investments that produce mostly capital gains or eligible Canadian dividends out of my RRSP. But that’s just my personal preference for tax efficiency. The picture in this link here definitely says otherwise.
Most people expect to be in a lower tax bracket when they retire so contributing money into an RRSP to defer taxation to a later date when their tax rate is lower makes sense. But some experts say it’s probably not a good idea to use RRSPs if we expect to retire in either the same or a higher tax bracket as we are in now. However, there might be another way to look at it. 😀
What if it’s still smarter to contribute to an RRSP today even if our marginal tax rate will be higher in retirement? When we make a tax deductible contribution to our RRSP today, the immediate tax relief we get is based on our marginal tax rate. So if our marginal tax rate is 30%, then we would receive $300 by contributing $1,000 to a registered retirement account. But when we withdraw money from this RRSP (or RRIF,) the money we take out is only taxed at our average tax rate, not the marginal tax rate. For example, if we request 12 monthly withdrawals a year from our retirement account then these payments would be taxed similarly to receiving work income from a job where each payment reflects our average income tax rate.
This is due to our progressive income tax system. In Ontario for example, the first $45K of income is taxed at roughly 21%, then the next $28K of income is taxed at 30%, and so on. So if we make $100,000, then we actually pay about $26,000 of income tax, which makes our average tax rate 26%, even though our marginal tax rate would be 38%.
So I’m going to continue maxing out my RRSP contributions each year even if there’s a chance my income will be higher in my 60s and 70s than it is now. 🙂
Random Useless Fact:
Some people on the internet can’t figure out how many girls are in this picture.