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RRSP tax benefit could shrink if cash-strapped governments act

Since its introduction in 1957, the registered retirement savings plan has become as much a symbol of Canadian self-reliance and security as the maple leaf.

But lately, the much-loved tax benefits of the RRSP could be under pressure from cash-strapped governments looking for extra revenue.

The premise of the RRSP is fairly simple. Savings can grow tax free until they are withdrawn in retirement when the plan holder is in a lower income tax bracket.

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For example, a person in Ontario with taxable income of $100,000 pays a top marginal tax rate of 37.2 per cent (26 per cent federal and 11.2 per cent provincial). At that rate, a $10,000 RRSP contribution would result in a tax savings of $3,720.

If that person retires with a taxable income of $40,000 a year, the federal/provincial marginal rate would be only 20 per cent. A $10,000 withdrawal would generate a tax bill of $2,000.

The success of an RRSP hinges on a primary assumption: that those marginal tax rates won't go up by the time we retire, perhaps decades from now.

Turns out it's already happening. In 2014, Ontario raised marginal tax rates for individuals making between $150,000 and $220,000 to 48 per cent, from 46.41 per cent, and 49.53 per cent from 46.41 per cent for individuals making more than $220,000.

"Ontario is under pressure because their deficit is in such a bad state," says Lorn Kutner, a tax partner with Deloitte Canada LLP in Toronto. "They're under pressure to increase revenues, and that's why they increased these tax rates."

Higher marginal tax rates have so far been confined to high-income Ontarians, but other jurisdictions are feeling the squeeze. Quebec is also deep in debt, and oil-producing provinces Alberta and Newfoundland and Labrador have admitted that a prolonged slump in oil prices will drain government coffers. The federal government is running a surplus, but much of its revenue also comes from oil.

Even if they don't hike marginal rates, governments have the ability to generate revenue by "playing with the brackets," Mr. Kutner says. That means adjusting the income dollar figures that determine the rates.

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Here's how: Federal and provincial tax rates move higher as the taxpayer's income rises. On the federal level, income below $43,953 is taxed by the Canada Revenue Agency at 15 per cent, while income above it – up to $87,907 – is taxed at 22 per cent.

The next $48,363 is taxed at 26 per cent to $136,270, and any income above that is taxed at 29 per cent. By shifting those dollar figures lower, more income would be taxed in the higher brackets.

For that reason, Mr. Kutner believes higher-income Canadians make a bigger target.

"There's a really low risk that people in the low- to medium-income thresholds will be caught by an increase in tax rates when they have to withdraw money from their RRSP. Those in a higher tax bracket are more at risk," he says.

He thinks most governments would be more inclined to raise or impose consumption taxes before boosting income tax, however. "I think they would likely raise the HST rate. Most economists think if you're tackling ways to reduce the deficit it's better to deal with a consumption tax than an income tax," he says.

To be on the safe side he suggests Canadians keep their taxable retirement income low by putting some of their savings in a tax-free savings account, where later withdrawals will not be taxed. "Those people who are not maximizing the use of a TFSA – assuming they can – shame on them because it's a great way to reduce your [taxable] income when you need funds out of your retirement vehicle."

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He says redirecting funds to a TFSA can also prevent the government from clawing back Old Age Security benefits if mandatory minimum RRSP withdrawals are too big in retirement.

Winnie Go, a Toronto-based senior wealth adviser with ScotiaMcLeod, also encourages her clients with large RRSPs to channel savings to a TFSA. "Look at your plan, see where your cash flow is, and if you are concerned your RRSP will grow too much over time, top up your TFSA first," she says.

As of 2015, the total TFSA contribution limit is capped at $36,500, but with a federal government vow to increase the contribution limit, which now stands at $5,500 each year, it is expected to become a more significant retirement-savings tool.

Ms. Go says it's already a good alternative for low-income individuals who reap smaller tax savings from an RRSP. "For younger people it's great to max out your TFSA, and when you're in a higher tax bracket you can get tax sheltered growth," she says.

That's not to say she believes TFSAs will always be tax free. As contributions increase and governments seek new ways to generate revenue, concerns have arisen over whether TFSA withdrawals will eventually be counted against OAS benefits.

"Even if you don't put money in your RRSP and you put it in your TFSA, they could change the rules down the road," she says.

The only alternative is to avoid RRSPs and TFSAs altogether, Ms. Go says. Some people, such as the wealthy and those who would rather avoid government at all costs, don't want RRSPs at all. "They will just save outside in a non-registered portfolio," she says. "They will have paid full taxes on their income along the way."

Even with non-registered savings, she says, it all comes down to that old saying about death and taxes.

"At the end of the day, they're going to tax what they're going to tax," she says. "If they increase it, it's not a good thing."

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