With the RRSP deadline right around the corner (March 2, 2009), this is a strategy that I’ve mentioned in passing a couple times, but never in great detail. That is, providing that the situation is right, you should consider carrying forward all or a portion of your RRSP tax deduction to a future year to maximize your tax return.
Who should do this?
I can see this strategy being useful in two situations:
- Higher Income in the Future. Recent university graduates are a prime example. New job, lower starting salaries, but some built up RRSP contribution room over the past few years. With higher future earning potential, thus higher tax rates in the coming years, it may make sense to carry forward the RRSP tax deduction to be claimed during years of higher income (thus higher taxes). This will allow the new grad to start building their investment portfolio to take advantage of the time value of compounding growth and obtain a larger tax deduction in the years of higher earnings.
- Claim just enough to drop to the next bracket below. As you may know, RRSP contributions result in a tax deduction which means that they reduce your income (and taxes owed) for the year. However, since the Canadian tax system is progressive (the more you earn, the higher your tax rate), it may make sense to contribute just enough to lower your income to the next tax level below. That way, your current RRSP contributions can be used for the higher tax bracket next year. This works especially well if you expect to make more money in future years.
How Much Will I Save?
Say for example that Andrew, from NL, makes $42,885 / year with a $10k contribution for 2008. Looking up his marginal tax rate, the amount earned above $37,885 will face 35.3% tax. Amounts from $37,885 to $30,215 will face 28.3% tax.
If Andrew were to claim the whole RRSP contribution this year, it would result in a tax return of ($5,000×35.3%) + ($5,000×28.3%) = $3,130. However, if he were to carry forward $5,000, then he would get an extra $350 back on his contribution (or 7% more) on his $5,000.
The caveat being that you need to account for the time value of money before using this strategy. Basically, the tax savings from waiting a year should beat any potential gains you would have made by investing/saving the money. Another thing to note is that sometimes the spread between tax brackets is small which makes this strategy not as effective.
Although carrying forward your RRSP tax deduction may not be for everyone, it works great for those who have a large RRSP contribution and would end up dropping down a significant tax bracket if the total contribution was claim in that year. It also works well in reverse. That is, if you expect to jump tax brackets due to increased income in future years.
As I mentioned above, if you only end up saving a couple percentage points, then it may not be worth your while to carry your tax deduction forward. You’ll have to decide for yourself whether or not your situation warrants carrying forward the RRSP tax deduction.
Do you use a similar strategy? Or do you simply claim your whole RRSP contribution every year?
As always, this post is for informational purposes only. Please consult a financial and/or tax professional before implementing any strategies mentioned on this blog.