Powerful tax-deferred retirement savings plan
Registered Retirement Savings Plans (RRSPs) are still the best retirement saving and tax-deferral opportunity available for most Canadians. Trouble is, many of us just don’t use RRSPs to their full advantage. Unused RRSP “contribution room” – that is, the amount of eligible RRSP contributions that have not been made – is currently over a trillion dollars. That’s a lot of contribution money that isn’t being tax-sheltered, and that is not giving anyone a tax deduction either.
The million-dollar growth machine
An RRSP is such a powerful retirement savings vehicle that most average wage earners can use it to retire with a million dollars. That’s because an RRSP lets you contribute a maximum of 18% of your “earned income” every year (less various “adjustments” related to pensions) to a pre-set maximum. For 2019, the maximum contribution limit was set at $26,500 (and because the contribution limit is indexed, it climbs to $27,230 for 2020).
The last day to make a contribution to get a deduction for the 2019 tax year is March 2, 2020. In addition, you can carry forward any unused contributions from 1991 on and use them as well. You also get a tax deduction on your contribution for a given year.
Here’s a tip to increase your contribution and your tax deduction: If your tax deduction results in a tax refund, reinvest the refund in your RRSP right away to keep that compound growth working for you. If you begin at age 40, and contribute, say, $20,000 per year for 25 years, at an average annual compounded 8% rate of return, you’ll retire with $1.7 million.)
Your investments grow tax-free inside an RRSP. You don’t pay tax until you withdraw funds from your RRSP at retirement, and then you pay tax on the withdrawals at your full marginal rate. But that will typically be lower than during your peak earning years.
In the meantime, where do you find those funds to contribute?
Automatic deposits. Start with your own resources. The easiest way to ensure you make RRSP contributions through the year is to arrange with your bank or your employer (if they’ve set up a group RRSP) to automatically deposit funds to your RRSP with every paycheque. You set the amount. The rest happens “invisibly,” just like any other withholding amount from your pay. Except in this case, the “withholding” remains in your hands as an RRSP contribution. And contributing through the year gets your money invested and compounding that much sooner. At the end of the year, you also get a tax deduction for contributions you’ve made.
Severance payments. If you received a severance payment in 2019 (and you put it aside for future use), use it now to make an RRSP contribution. That way, you’ll shelter some or all of the severance amount from income tax.
Inheritances. You may have received a bequest during the year. If it’s a substantial sum, use at least some of it as an RRSP contribution. Bequests themselves are generally not taxable as income, but any investment income from that bequest is. So contribute some of it to an RRSP, where investment growth is tax-sheltered until your RRSP matures.
Contributions in kind. If you have qualifying investments outside an RRSP in a non-registered account, consider transferring some of them to an RRSP. Their current value will be deemed to be the contribution amount for tax purposes. Any RRSP-eligible investment will do, including stocks traded on listed exchanges, GICs, Canada Savings Bonds, government bonds, mutual funds, ETFs, and so on.
If you make this type of contribution, keep in mind that there will be what’s called a “deemed sale” of the asset, and 50% of any capital gain may be taxed. However, the upside is that you’ll get a tax deduction on 100% of your contribution. To make contributions in kind, you’ll need a brokerage account or have a self-directed RRSP that lets you pick and choose your own investments.
Should you borrow your contribution?
It seems like the best of all worlds. You’ll get a tax deduction on the contribution, you’ll be able to pay down the loan with your refund, and your investment could well earn more than the interest on the loan. But there are a few downside risks to consider.
The biggest is that you are leveraging your investment. It makes no sense to put borrowed money into a safe, interest-bearing investment like a GIC, because it earns less than the cost of your loan. But if you invest in equity investments, either directly or through a mutual fund or ETF, you run the risk of magnifying any losses that may occur. In other words, the value of your investment may end up being less than the value of your loan – never a good situation! Another minus is that you don’t get to deduct interest on loans used for RRSP contributions.
Remember, too, that an “RRSP loan” is still a loan – a debt with interest payable. And you must make the payment to the lender (usually your friendly neighborhood bank) when it’s due, regardless of what happens to your RRSP investment or anything else. People who jump into RRSP loans without thinking about the effect on their cash flow are usually in for a rude awakening.
Use your spouse as a tax break!
One of the very best ways to split income is the spousal RRSP. Essentially you contribute funds to your spouse’s RRSP, and you get the tax deduction. But your spouse gets the tax-sheltered compounded growth. It’s a great way to get a tax break and keep it all in the family, too.
Do not overcontribute!
RRSP contribution limits are very generous. But at times you may find yourself in a position to contribute a massive amount to your RRSP. If so, make sure you have enough contribution room in the current year, including any contribution room carried forward from previous years. If you overcontribute, you’re liable for a stiff penalty tax of 1% per month up to 60 months on excess contributions above $2,000. In addition, you’ll have to file Form T1-OVP to report your overcontribution. If you don’t, you’ll be liable for even more penalties and interest. And if you are considering a large contribution, beware the Alternative Minimum Tax! If AMT rears its ugly head, consider deferring some of the RRSP deductions to a future year.
All in all, it’s vitally important to get your contribution amount for the year just right. Getting the advice of a financial planner might be wise at this point.