Expecting your income to drop? This tax hack could save you thousands of dollars.
Since launching in 2009, the Tax-Free Savings Account (TFSA) has been wildly successful. So much so, that many people we sit down with believe that the TFSA is better than an RRSP (Registered Retirement Savings Plan).
The truth is, one isn’t better than the other. They have different benefits and drawbacks and how you utilize each is entirely dependent on your individual circumstances. Figuring out which to prioritize is more difficult than many people realize. Here’s a good illustration of that if you’re interested.
When making these comparisons, keep in mind there’s a great RRSP hack that most people overlook which can generate a big fat tax refund for very little effort. And it doesn’t work for your TFSA.
The catch is that it only works if you know your income will be dropping meaningfully in a future year. For instance, you might be planning on starting your own business, going back to school, taking parental leave, in between jobs for a while, or just taking an unpaid leave of absence.
I’ll use a specific example to illustrate the strategy. Just remember, I’m simplifying a lot of the details to keep you from falling asleep.
Let’s say you’ve worked hard throughout your career but have always wanted to branch out and start your own venture. You’ve got a decent sized nest egg and your spouse has a good steady income. And, at long last, you’ve finally found the nerve leave your job and do your own thing. The good news is, you’re excited and are pursuing your life dream. The bad news is that you won’t be making much money for a while.
The job you left was paying you $130,000 a year. Next tax year you’re expecting to claim only $20,000 in income. This means your marginal tax rate (living in Ontario) will go from roughly 43% all the way down to 20% next year.
Knowing all of this, you could take say $40,000 out of your savings and contribute it to an RRSP (if you have the contribution room). This will result in a tax savings of over $17,000. But now $40,000 of your savings is stuck in your RRSP. So you’ll want to get it out.
The silver lining to the fact that your income is about to drop off a cliff is that it means your tax rate will as well. In fact, you may never be taxed at such a low rate again; including in retirement. This is a great opportunity to withdraw money from your RRSP.
Starting in the following tax year, you could withdraw $20,000 from your RRSP for each of the next two years. Most new businesses take some time to build up steam. So your income for the next couple of years should be pretty low.
If your income stays below $42,000 annually for the next couple of years (including the $20,000 RRSP withdrawal that you’ll have to claim as income), you’ll only be taxed at a 20% marginal rate.
Sure, having to pay 20% tax on that money isn’t great. But you’ll be taxed on it someday whether you like it or not. And even in retirement you probably won’t be in such a low tax bracket.
Hopefully, it’s obvious that, when you net this all out, you win on this trade. You received a tax break at 43% when you contributed to your RRSP and paid tax at 20% (in this scenario it would be lower than that, but I won’t get into those details right now). So, the difference between what you saved in tax and paid in tax is $9200.
That’s close to $10,000 in your pocket simply because you moved money around using the right accounts. That’s money that could be put back into your business, spent taking the family on a trip to Costa Rica, or invested.
This hack also works if your income is dropping for other reasons too (taking parental leave, in between jobs for a while, taking an unpaid leave from work, etc). The general rule is that the more your income is expected to fall, the better this hack works.
Just keep in mind, there are a lot of moving parts here. There are some drawbacks you’ll want to consider. I’ve simplified the discussion for the sake of brevity. I strongly suggest that you get some help from a professional before attempting this. A good financial advisor can help you think through the details and ensure the strategy makes sense for you.
Lastly, this is just one potential tactic to consider within your broader financial strategy. As I’ve written about before, the key to a sound strategy is having a documented financial plan in place; this is the single best thing you can do to improve your odds of long-term financial success.
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About the Author
David O’Leary is Founder & Principal of Kind Wealth and host of The Impact Investing Podcast. He is the former Managing Director of Origin Capital; a provider of high-impact investments that provide an opportunity for the world’s most vulnerable people in the hardest to reach places. Read Dave’s bio or connect with him on LinkedIn.