Retirement accounts are generally lauded for being tax friendly.
But what if you’re a high income earner? 🤔
Can contributing to a tax advantaged retirement account hurt you instead of help you?
Yes. I’ll demonstrate how in today’s post.
A lot of readers here make over $100,000 a year.
So let’s approach retirement planning from a taxation and inflation perspective.
Tax brackets change over time
Let’s say you were making $200,000 a year as a software engineer in 2012 in Vancouver, BC.
And you plan to retire 10 years later in 2022.
According to the Motley Fool, you would need 80% of your 2012 income to retire comfortably.
80% of $200,000 is $160,000.
Since $160,000 is less than $200,000 you contribute to your RRSP in 2012 which defers your income to a future date. The plan is to be in a lower tax bracket when you withdraw the funds in retirement. 🙂 If you live in the United States, the RRSP works pretty much like the IRA, individual retirement account. 🙂
Fast forward to today.
You retire and live on $160,000 a year.
Except over the last 10 years the cost of living increased by 21.12%.
So instead of living on $160,000 you have to live on $193,792. (21.12% more)
Here’s a chart of the different tax brackets by income.
The blue line represents the marginal tax rates in 2012.
The red line represents the marginal tax rates in 2022.
In 2012, when you were making $200,000, your marginal tax rate was 43%.
Today, your income is $193,000. And your marginal tax rate became 46%, higher than when you were working.
Uh oh. 🤔 The point of using an RRSP is to defer and reduce your overall income tax payable.
But in this situation the outcome appears to be the opposite of what you want.
This is why people shouldn’t just assume they’ll spend less in retirement than their working years.
Yes, they can live on less “real” income in retirement, but their nominal spending could be the same, or higher.
All thanks to inflation.
The 21% inflation rate over the last 10 years is simply the official number from the Bank of Canada.
Of course everyone’s personal inflation rate will be different.
Keep in mind that basic necessities like housing, food, and healthcare costs have increased by a lot more.
Also income tax rates could increase in the future, adding to the tax burden in retirement.
Personally I do not max out my RRSP contributions anymore.
I still contribute fully to my TFSA though. 🙂
Sources for my graphs:
Certain data points are not yet available for 2022 so I’m substituting some information from 2021.
Random Useless Fact:
Nature is constantly evolving.