Using your RRSP to level your income while you are working…

Certainly you may know that making a contribution to your RRSP will allow you to reduce the taxes you pay in a given year. And you know that in exchange for allowing you to deduct the contribution from your income now, you will have to claim the withdrawal of funds from your RRSP as income in exchange (and be fully taxed on it). And of course, while the money is in there for a long period of time, it is expected to grow faster since the RRSP is a tax-shelter.

QuestionMark.jpgBut RRSP’s aren’t always used for retirement planning.

Many people with cyclical income can use it as a way to level out their income in a very tax-advantaged manner. This would be applicable to salespeople or pretty much anyone who experiences years of high income and subsequent years of lower income. If your income levels vary substantially and tend to work in cycles – then you certainly will want to look at this strategy.

In a nutshell, you would make and claim RRSP contributions in years that you have high earnings and then make RRSP withdrawals in years that you have low income. The theory is that if you make the contribution when your earned income is very high – you get a refund based on a high tax bracket. When you make a withdrawal and you are in a lower tax bracket – you pay tax on that money at a lower rate than when you contributed it. Therefore you are able to effectively reduce the amount of taxes paid on your income.

One trade-off to note is that you will burn up RRSP room – so you have to weigh your retirement savings plans against this strategy to see if this makes sense for your situation.

But let’s assume that our test subject (let’s call him George) decides to save for retirement in a non-registered account as many people might actually do these days. Let’s also use an extreme example (just to make the point clear). George works as a contract aerospace engineer. He earns $100,000/year when on contract and he likes to work for one year and take a year off. Then he will go back to work for a year, and subsequently take the following year off, etc.

Scenario One

In this scenario, George puts some of the money that he earns while working into a savings account and subsequently uses it in the years that he is not working. So when he is working and earning $100,000, he is paying $30,000 in tax. That leaves him with $70,000 to spend. He spreads this out over two years and therefore is able to get by spending approximately $35,000 per year.

Scenario Two

In this scenario, George puts money into his RRSP. Since he is limited to contributing 18% of his income we will assume he only contributes $18,000 to his RRSP for the tax years in which he is earning $100,000. This entitles him to a reduction in the taxes owed for that year. Depending on which province you are in, you are getting a reduction in taxes of about $8,000. The following year, when George has no employment income, he withdraws the entire amount out of his RRSP. Again, depending on which province you are in, you are paying in and around $2,000 in tax on a $18,000 RRSP withdrawal (if there is no other income for that year).

So in effect, he has reduced his tax bill by $6,000 over that two year period. His spending per year has gone up from $35,000/year to $38,000/year. But remember, for this particular example George has completely burned up his RRSP room in order to do this, so it would be expected that he saves for retirement out of his annual expenses in an alternate manner.

This scenario can also be used for people with NON-cyclical income, but just happen to be unemployed for a year. In this case, assuming you were using your RRSP for retirement savings you need to carefully weigh the long term cost of taking funds out of your RRSPs. Certainly, when you are in need of money for the here and now, savings for retirement is a luxury and not as much of a necessity as making the mortgage payment. :(

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Preet Banerjee
Preet Banerjee an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 12 comments
  • jules

    thanks for this post! i’ve been having a hard time finding out what the best strategy may be for a person like me who wants to take a year off to travel (i don’t have the luxury of setting it up as a sabbatical with my employer so i’m saving up for it all on my own). i don’t have an rrsp setup yet (gasp), so might it be best for me to setup an rrsp, contribute to it for 5 years or so (or whenever i plan to leave) and then pull out part of it, or all of it when i want to take that year off?

    • Leroy

      You may lose or reduce any gov. benefits you normally receive if family net income reported is too high with RRSP withdrawal..

      • Preet

        An excellent point – thanks Leroy.

  • Preet

    Hi Jules, you would have to make sure that it fits into your overall plans of course – and that includes the impact it could have on your retirement planning.

    I would suggest sitting down with a financial planner to really hammer out the details, weigh the pros and cons, etc.

    An accountant could also help verify the tax effects for your own situation.

  • jules

    thanks. :)

  • Ron

    I’m considering this strategy for my wife who will be taking a year off for maternity leave. I’m just not sure if RRSP withdrawals will affect her maternity EI benefits? Will EI consider this income and reduce her benefits?

  • Preet

    For EI you can get away with withdrawing money from your RRSP and not have that affect your earnings for the purposes of calculating EI benefits.

    Click here to see text from Service Canada that confirms this.

  • Ron

    That’s great. Thanks!

  • Irene

    Could I contribute in jan 2010 for 2009 for my high income year and withdraw in say april 2010 for a low income year?

  • tash

    Can I still contribute to an RSP account while on Mat Leave (EI)???

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  • […] out if you’re intrigued by this and would like to read another take on it.  Tim Cestnick, Where Does All My Money Go? (Preet is Mr. RRSP), and  Efficient Market Canada each have more information about this […]

  • […] out if you’re intrigued by this and would like to read another take on it.  Tim Cestnick, Where Does All My Money Go? (Preet is Mr. RRSP), and  Efficient Market Canada each have more information about this […]