The 5 RRSP Refund Strategies

How Pasta can Increase RRSP Income 25-100%

Now we can get back to pasta and introduce the “can’t lose” strategy that can increase your RRSP income 25-100%.

Since RRSPs are the core of most Canadians’ voluntary retirement savings, every investor needs to know the answer to the RRSP Pasta Question.

One of the core concepts that the wealthy understand is after-tax versus before-tax dollars.  

To answer the RRSP Pasta Question, we need to understand the difference between after-tax dollars and before-tax dollars, as it relates to investing in RRSPs.

Let’s consider Typical Ted again.

We’ll assume that Ted has $1,000 after tax to invest. And to keep the math as simple as possible, we’ll pretend he’s in a 50% tax bracket. When Ted earns $2, he loses half to the government and is left with $1. This means that $2 before tax is worth $1 after taxes.

Considerable effort went into choosing realistic parameters that produce nice, round numbers to make it easier to understand the math and how the concepts work. This is also why 50% and 33% tax brackets are used in the examples.

As I strongly emphasize in The Smart Debt Coach, and in every seminar and workshop I do, your behaviour — both as a consumer and an investor — is the critical factor to your financial success. And it’s one of the few parameters that you can completely control.

The key to financial success is not what you know, it’s what you do.

The behavioural reality with RRSPs is that there are 5 RRSP Refund Strategies, each representing different types of behaviour, specifically what happens with the RRSP refund. 

In fact, the refund creates an RRSP “behaviour trap” that most aren’t aware of.

What do you typically do with the majority of your RRSP refunds?

a)  spend it

b)  pay down debts and/or mortgage

c)  reinvest in RRSPs

d)  other investments

e)  other

My experience speaking to Canadians coast to coast is that over 90% of Canadians spend their RRSP refunds. For many, RRSPs are Registered Retirement “Spend the refund” Plans. In fact, I would suggest that some mentally spend their refunds before they make the contribution!

The key to financial success is not what you know, it’s what you do.

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RRSP Refund Strategy 1: Spend

So the first and most common RRSP refund strategy is to spend it.

Typical Ted invests in RRSPs on an ad hoc basis, and when he does, he spends his refunds.

But if Ted puts $1,000 in his RRSP, and spends the refund, how much has he really committed to generate retirement income?

If he spends the $500 refund, rebate, discount, whatever you want to call it, his net, after-tax cost is only … $500.

Recognize that it’s easy to be misled. It’s easy to think that if you put $1,000 in your RRSP, and like most, spend the refund, you’ve contributed $1,000 towards your retirement. The transaction confirmation shows a $1,000 deposit.

Most people understand that money in an RRSP is fully taxable when withdrawn. An RRSP is really just a government-approved tax deferral program.

But what most don’t fully understand is that by contributing to an RRSP and spending the refund, you fall into the RRSP “behaviour trap” and end up converting your after-tax dollars to before-tax dollars, to be taxed again later.

If Ted’s $1,000 to invest only produces a $1,000 RRSP contribution, he doesn’t invest all of the money he started with. In our fictitious example, he invests half as much.

To avoid the RRSP “behaviour trap,” we need all investors to know that if you spend your RRSP refunds, you end up investing less than you started with, less than you think, and less than intended for retirement.

RRSP Refund Strategy 2: Reinvest

Assuming Ted’s goal for the initial $1,000 is to fund a retirement that might last 30 years or more, what else could he do with the refund instead of spend it?

Obviously, Ted could reinvest the refund. And if he reinvests the $500 refund back into his RRSP, he ends up with a total contribution of $1,500.

In a 50% tax bracket, simply reinvesting Ted’s refund increases his initial RRSP contribution by 50%. This means his resulting retirement income will be 50% higher as well.

If Ted had the discipline to reinvest his refund, what would be the after-tax amount of his contribution? How much after-tax fuel would he put in his retirement vehicle?

In a 50% tax bracket, if he cashed the $1,500 out of his RRSP the next day, what would he have left?

He would lose half to taxes. So he’d have $750, right? Ted started with $1,000 after tax to invest, and by reinvesting his refund, he’s contributed $750 after tax.

To avoid the RRSP “behaviour trap,” we need all investors to know that if you spend your RRSP refunds, you end up investing less than you started with, less than you think, and less than intended for retirement.

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Ellen Roseman

Toronto Star personal finance and consumer columnist, author and adult education instructor

I spent my RRSP refunds until Talbot Stevens showed me the math on reinvesting them. Now he’s written a book that uses the catchy concept of dry pasta to help you understand a better way to a comfortable retirement.

The good news is that some RRSP discussions are starting to talk about what happens to the refunds, and the need to reinvest them. Some RRSP calculators and illustrations now contrast unregistered investing to both RRSPs, and RRSPs with the refunds reinvested.

The bad news is that this is still only part of the story.

And this is where the pasta metaphor comes in.

Even an amateur sous chef like me knows that when you cook it, dry pasta becomes much larger as it absorbs water.

Pasta is an effective, albeit off-the-wall metaphor, illustrating the difference between small, after-tax dollars — those that we get to spend or save — and larger, before-tax dollars, like those in an RRSP.

When you come to with $1,000 to invest, it is generally after-tax dollars — dollars that have already been reduced by taxation. In other words, smaller, dry pasta.

If Ted reinvests the $500 refund for a total contribution of $1,500, this is much better. But it is only partially cooked pasta. He’s added some water to make his contribution 50% bigger, but he can do even better.

RRSP Refund Strategy 3: Gross Up

In a 50% tax bracket, $1,000 of after-tax money equates to, not $1,000, not $1,500, but $2,000 in an RRSP.

Why? Because if Ted had $2,000 in an RRSP, withdrew it and lost half to income taxes, he’d be left with $1,000 after tax.

So, in Ted’s case, $1,000 to invest equates to $2,000 before-tax. That’s how much his initial $1,000 could and should become in an RRSP.

That’s the third RRSP refund strategy, what I call an RRSP Gross Up, where you ‘gross up’ your initial after-tax dollars (dry pasta) to the full equivalent, before-tax amount (fully cooked pasta).

How to Gross Up

So how do you gross up your RRSP contribution?

The easiest way to understand is to use a short-term Gross Up loan — one of the few “can’t lose” investment debt strategies.

You start with the after tax amount you have to invest. Then you figure out the equivalent before-tax, RRSP amount, and borrow the difference.

In this illustration, Ted has $1,000 after tax to invest, and we’ve assumed a simplified 50% tax rate. We know this equates to $2,000 before tax in his RRSP. So late in RRSP season, Ted borrows the difference. He borrows $1,000 and with his initial $1,000, he makes a $2,000 RRSP contribution.

A few weeks later, he files his taxes and gets a refund for half of the $2,000, or $1,000. The $1,000 refund is enough to completely, and almost immediately, repay the temporary Gross Up loan, if we ignore a few dollars of interest.

By using a Gross Up strategy, Ted invests ALL of the after-tax money he started with, and gets all of the money he intended for retirement, invested for retirement.

In this case, he’s doubled his RRSP contribution, and is 100% better off compared to the common approach where his refund is spent.

The other way to Gross Up your after-tax dollars to the full, equivalent RRSP amount is to increase your monthly savings plan by the appropriate amount and adjust your withholding taxes with your employer, by filing form T1213.

This eliminates getting a tax refund in April, and the behavioural risk of spending it.

TIP

For ad hoc or Gross Up loan investors, here’s a convenient and effective way to remove the behavioural risk of spending tax refunds.

When you file your tax return, indicate that you’d like the refund to go directly into your investment firm’s account instead of your personal account. This pre-commitment guarantees that the refund is reinvested as intended instead of being spent.

We know that with a 50% tax bracket, you would increase your monthly savings by 100%.

For other tax brackets, see or you can visit my RRSP Pasta web page at www.SmartDebtCoach.com/Pasta. For math geeks, calculating the Before-Tax amount is trivial.

Before-Tax amount = After-Tax amount / ( 1 - Tax Rate ). Or, using variables, BT = AT / (1 - TR). This follows from: AT = BT - TAX, and TAX = BT x TR. Thus, AT = BT - BT x TR, or AT = BT x (1 - TR). Thus, BT = AT / (1 - TR).
 

On the RRSP Pasta web page, I have a free RRSP Gross Up calculator, as well as free access to the 6-page chapter from The Smart Debt Coach that explains these ideas and can be shared with your friends.

EXAMPLE

Mary is in a 33% tax bracket, and has a $1,000 after tax to invest. Using the RRSP Gross Up calculator, we see that Mary’s $1,000 can be Grossed Up to a $1,500 RRSP contribution.

Because of the intentionally simplified parameters, this can be confirmed in your head with grade 4 math. If you had $1,500 of before-tax RRSP money and lost a third to taxes, it would be worth $1,000 after taxes. Of course, math geeks can get the same result with the formula: Before-Tax amount = After-Tax amount / ( 1 - Tax Rate ). So, the before-tax, Grossed Up RRSP amount = $1,000 / ( 1 - .33 ) = $1,500.

One Final Point

There’s one final point about this after-tax, before-tax, pasta message that is critical for RRSP investors to understand.

If you don’t invest the equivalent, before-tax amount in your RRSP — the Grossed Up amount as I call it — you’re not putting all of the fuel that you start with in your retirement vehicle. Clearly, how far down the road your retirement vehicle takes you depends both on how tax efficient it is, and how much fuel you put in it.

If by spending your refunds, you end up putting half as much fuel into a more efficient vehicle, we don’t need a fancy computer to conclude that you’d be better off not using RRSPs. You’d get farther in retirement by investing all of your fuel into TFSAs or even a taxable investment. With these investing vehicles, there’s no behavioural risk that some of your fuel intended and needed to fund your retirement ends up used for something else.

So, when saving for retirement, understand after-tax versus before-tax dollars, the impact of your behaviour, and the 5 RRSP refund strategies. Make sure you don’t put dry pasta in your RRSP, or you could be better off not using RRSPs at all!

RRSP Refund Strategy 4: Top Up

The fourth RRSP Refund Strategy is where you use a loan paid off within a year to “Top Up” your contribution, perhaps to the annual limit.

Like Mary, Ted has $6,000 to invest, and is actually in a 33% tax bracket.

He could Gross Up his contribution to $9,000 by temporarily borrowing an extra $3,000.

Use my free RRSP Gross Up calculator to determine this value. See the Free Resources in the Contents menu or the Next Steps section.

The $9,000 RRSP contribution produces a tax refund of 33% of $9,000 or $3,000. This completely repays the loan a few weeks after filing income taxes.

To make up for missing last year’s contribution, Ted could instead Top Up his RRSP by adding $12,000 this year. He could borrow $6,000 to combine with his $6,000. The refund is a third of $12,000 or $4,000. He would then use the refund to immediately reduce the Top Up loan to $2,000, to be paid off within the year.

Top Up loans are universally accepted as a good idea.

But good doesn’t mean best.

Since the interest when borrowing for RRSPs is not tax deductible, it would be better for Ted to use an automatic PYF savings plan to avoid the interest cost, and reduce the risk that he skips a contribution.

Ted should Gross Up his contribution, and he could use a Top Up strategy to contribute a bit more.

But he recognizes that he’s skipped RRSP contributions two of the last 10 years. Like most Canadians, Typical Ted has tons of unused contribution room. He knows he’s behind in his retirement savings, and is starting to be concerned about it.

Is there a better way?