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:
https://www.canada.ca/en/financial-consumer-agency/services/financial-toolkit/taxes/taxes-2/5.html
https://www.taxtips.ca/priortaxrates/tax-rates-2011-2012/bc.htm
Certain data points are not yet available for 2022 so I’m substituting some information from 2021.
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Random Useless Fact:
Nature is constantly evolving.
Hind sight is always 20/20.
If we knew/know what salary we will be making in 20 years from now it would be much easier to plan ahead.
High income earners who are sure of their income in the years ahead would more than most likely be better off having a non-registered portfolio as tax treatment of the dividends would be more favourable than income from a RIF/LIF
TFSA still beats them all for tax implications. The only limit is the amount you can put in to it each year. Still can be a sizable amount if you have been doing it over your working life. Anyone who can afford it now should be maxing out every year. It could amount to well over a million $ by the time you retire.
RICARDO
That’s my thinking as well Ricardo. 🙂 A non-registered or TFSA portfolio can give way more benefits and flexibility to high income earners than a retirement savings account. Building up a $1 million TFSA will take some time, but it’s very doable with patience and discipline. 👍
Very insightful Liquid! I always considered maxing out my RRSP to be the goal, but this made me think of other factors I didn’t have already.
Originally the RRSP was the only ubiquitous and easily accessible vehicle to let your investments grow tax free. But now we have the TFSA which also shelters investments as they grow tax free. A non-registered account can give you access to margin, leverage, flexibility, and complex options strategies to potentially improve your returns. So the RRSP is looking less appealing.
But maybe there is a time and place to use it. For example, if I were in the highest tax bracket of 54%, I could contribute strategically to my RRSP to lower my taxable income just enough to fall into the 46% marginal tax rate. 🙂
I don’t plan to have an RRSP since I am not in a high tax bracket.
I max my TFSA with VEQT every year since I was 19 yrs old. I am 24 now.
I plan to FI earlier and move my taxable account distributions into my TFSA each year.
The plan is to have the bulk of my assets in my TFSA when I am at traditional retirement age.
That’s a smart plan. Income withdrawn from a TFSA is not taxable so when you reach traditional retirement age you can qualify for maximum government benefits. Sounds like you’ve learned a lot for someone your age. Well done.👍
I think looking at the marginal tax rate for the year you contribute to RRSP makes a world of sense. That’s (at least roughly) the true tax refund/savings.
But for the future retirement year when you withdraw from the RRSP it’s not so clear cut the marginal rate is the sensible comparison.
For an early retiree in particular, most/all I have for income could be RRSP withdrawals.
When withdrawing say $193000 as per your example, my average tax rate would only be 32.05%. That is a non-trivial improvement over the 43% I would have paid in the year I earned it.
Yes my marginal rate at that point would be 46.12% but I don’t think that’s the number to focus on there.
Of course ymmv; if you have other pension income, taxable investments, OAS, etc. things can shift around. But I think looking at average rate on withdrawal is important.
That’s very insightful Geoff. I understand what you mean. Contributing to an RRSP directly impacts you at the marginal tax rate. But it’s not so clear when withdrawing from the RRSP or RRIF in retirement. 👍
There’s validity in considering the average tax rate. I just don’t know if it’s directly comparable. It’s very hard for someone’s average tax rate in retirement to be higher than their marginal tax rate while working.
I honestly don’t know what is the correct way to analyze it. 😅 Maybe someone who understands accounting or actuarial math can help, lol.
wow that’s quite an interesting way to look at it. The untamed inflation rate has definitely complicated retirement planning. I agree with the comments below that maximizing TFSA would be a smart strategy.
If only the TFSA had more contribution room, haha. And yeah, inflation can be a real drag on people’s finances. 🙂
I think replacing my current income with retirement income won’t be possible 🙁
I would need to have obscene amounts invested and get a decent yield to do so.
Sadly I have colleagues who worry – can I live on 250K a year… this is because they are currently spending more than that and would be taking a pay cut to 250K.
I wonder what expensive hobbies high spending households engage in. Maybe a lot of golfing, lol. Or horses. 🐴
This does not take into account the present value of the tax saved.
(i.e. you get that money now, it can grow, then with future dollars, is paid back at similar past rate. It’s like borrowing your tax money from the government to invest, similar to CESG grants for RESP if your kid doesn’t end up going to school.)
Ah, right. I forgot to factor in the present value of the tax refund from the contribution. I wonder how that would change the outcome. It probably depends on the discount rate you choose, and investment returns. Thank you for bringing up an excellent point, Devin. 😀
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Also depends on if you have a spouse and if both have RRSPs/Spousal RRSPs (pre-age 65) or can income split at 65. Currently in Ontario, each can pull out $46K ($92K total) and still be in lowest tax bracket (assuming no other sources of taxable income). Thank goodness spending creep is not in my nature – I would not know how to spend $160K per year.
Great point. Income splitting can help a lot. 🙂 I wouldn’t know how to spend $160K a year either. If inflation remains elevated through the next decade then maybe that kind of spending would become the norm for a lot of people, lol. But I hope that doesn’t happen.