Should I still contribute if I am taking a year off work?

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The question

I am taking a year off work to learn a language and volunteer. I will not have any income (but will use my savings for living expenses). In the past, I have always contributed the maximum to my RRSP and TFSA. Since I won't have income, do I still file a return and should I still make RRSP and TFSA contributions, or wait until I start working again? Is there a difference in what is most beneficial?

Thank you kindly, Natalie

The answer

Hi Natalie,

You may have accidentally discovered a great RRSP strategy for yourself, with your year off. Not only should you not put money into an RRSP this year (if you use cash to contribute, use up all of the TFSA room that you have), but you should probably take money out of the RRSP in 2012. This strategy could create a gain of 20-plus per cent just from tax benefits. Here is why.

Let's assume that you had a salary of $100,000 last year. When you made a $20,000 RRSP contribution, you received a tax refund of roughly 40 per cent or $8,000.

In 2012, if your income will be $0, you can turn around and take out $20,000 from your RRSP. You will pay maybe $2,000 in tax, leaving you with $18,000.

In 2013, if your income is once again $100,000, you can take the same $18,000, put it into your RRSP in that year, and get another 40 per cent refund, or roughly $7,200.

In the three years, you will have put in a net contribution of $18,000, but received a net refund of $13,200 ($8,000 plus $7,200 minus $2,000) or 73 per cent!

The drawback is that you have given up some tax sheltering. The other drawback is if you are married, you will give up a spousal tax credit by taking out the $20,000 from your RRSP. Even with both potential drawbacks, the ability to get a 73-per-cent refund on RRSP contributions makes this a great opportunity. This strategy can also work well for those who are unemployed or staying home for a few years to raise children.

This situation underscores the key driver of whether to make an RRSP contribution, make a withdrawal and/or put money into the TFSA. The key is that if you have a year with at least $40,000 of income and it is a normal income year or higher, you will probably want to make an RRSP contribution first. If your income is under $40,000 or it is a much lower than normal year for your income, you probably want to contribute to a TFSA first. If you have a rare year where your income is going to be very low or $0, you should consider taking money out from your RRSP because you can draw the money out at a tax rate much lower than the tax refund was when you put the money in.

Ted Rechtshaffen is president and CEO of TriDelta Financial Partners, a firm that provides independent financial planning advice. He has an MBA from the Schulich School of Business and is a certified financial planner. Follow Ted on his blog at The Canadian Financial Planner.

For tips, stories, videos and live chats ahead of this year's RRSP contribution deadline, check the Globe Investor 2012 RRSP season section for daily updates.