Many employees look forward to this time of year because it’s when they can expect their bonuses for the year prior.
Most employers plan to pay them out before the end of February, partly so employees can use the funds to make RRSP contributions against the previous year’s income. Often, employers will go further by routing the gross—with no federal or provincial income tax withheld—directly into a group RRSP.
For a conscientious RRSP saver, this is a great way to ensure contributions are being systematically socked away. However, it’s important to understand the mechanics of this process to avoid a nasty tax surprise.
Timing, source of RRSP deposit
For 2016, the 60-day RRSP deadline was Monday, February 29; after that, deposits can’t be claimed against 2015 income (for 2017, it’s Wednesday, March 1). When a bonus is deposited directly into an RRSP, with no taxes withheld, it means income taxable in 2016 is being used to reduce income taxable in 2015.
To illustrate, let’s assume Bonnie claimed no RRSP contributions for 2014, and her marginal tax rate is a constant 40%. She earned a base salary of $90,000 paid in 2015, and a bonus of $10,000 paid in February 2016. By making the RRSP contribution in February 2016, she reduced her 2015 taxable income to $80,000, yielding a tax refund of $4,000. If Bonnie earns the same $90,000 base salary this year, her total income will be $100,000 in 2016.
Unfortunately, Bonnie is terminated at the end of 2016 and is not entitled to any further bonus payment.
Next year’s return
It’s April 2017—tax-filing time. Bonnie’s employer rightly withheld the tax due based on her $90,000 base salary, but Bonnie actually earned $100,000 in 2016. She now owes another $4,000 in tax (i.e., 40% of $10,000). If Bonnie had the foresight to set aside the refund money when she received it in the spring of 2016, she would have the cash necessary to pay the difference.
This asks the question: What should Bonnie have done with the refund? A common recommendation is to make a further RRSP contribution with any refund generated from an RRSP contribution. This enables the taxpayer to boost the RRSP each year by repeatedly applying the tax refunds to pre-fund the tax liability on the eventual drawdown.
But in this case, had Bonnie made that second RRSP contribution, it would have generated a corresponding refund of $1,600 (40% of $4,000). That certainly would have helped build her retirement savings, but from a cash-flow perspective, she would still be $2,400 short of the $4,000 she needs to pay her 2016 tax on the bonus.
Could it be worse?
On a rolling annual basis, if Bonnie has a consistent income and RRSP deposit habit, this issue may never have been noticed, at least not until the year after she retires.
On the negative side, what if Bonnie had a $40,000 one-time bonus that she used to catch up on carry forward RRSP room? This could play havoc with her cash flow when it comes to filing her taxes the following year.
Be aware that premiums for Canada Pension Plan and Employment Insurance are applicable to bonus payments. So, if the full bonus is directed to an RRSP, the employer will be taking those CPP and EI deductions out of the employee’s regular pay.
Though not as substantial as the income tax implications, the deductions explain the slightly lighter regular paycheque the employee would receive at February month-end.
Doug Carroll, JD, LLM (Tax), CFP, TEP, is Practice Lead — Tax, Estate & Financial Planning at Meridian.