This year, the registered retirement saving plan (RRSP) turns 55, an age which many Canadians have targeted for retirement. You would think that the basic idea behind RRSPs—the straightforward notion of contributing savings to a registered plan in which earned income would remain tax-free so long as it remained in the plan—would be ingrained in Canadians’ minds.
Yet based on the fact that for the past two years, only about a quarter of eligible tax filers actually contributed to RRSPs, it would be unwise to assume that most investors are truly familiar with even the basics of these plans, let alone the strategies they can use to improve their tax picture.
Since we’re now well into the 2013 RRSP season, it’s a good time to quickly review the fundamentals and discuss some of the strategies your clients can use to enhance their savings.
Investors, their spouses or common-law partners are allowed to contribute cash or “in kind” contributions, such as equity and fixed-income investments at fair market value to RRSPs. These contributions generate deductions that are reported on line 208 of their income tax returns. The allowable sizes of these deductions in any given year are determined by the amount that has been contributed previously to their plans, and by their RRSP deduction limits.
The RRSP deduction limit refers to the maximum amount they can deduct from contributions made either to their own plans or to their spouses’ or common-law partners’ plans in the previous taxation year. Limits are calculated using a variety of factors, including the previous year’s earned income, past service pension adjustments, pension adjustments reversals and unused RRSP deduction room from previous years. Deduction limits are also partly determined by the federally mandated RRSP dollar limit. That refers to the maximum amount of new RRSP deduction room that can be created in a particular year. For 2011, the limit was $22,450, but it will rise to $22,970 in 2012 and to $23,820 in 2013.
Broadly, the deductions your clients make on their tax returns for their RRSPs cannot exceed the dollar limit, their deduction limits, or a combination of unused contributions from a previous year, contributions for the current year and contributions made within 60 days of the December 31 tax year-end.
Clients should also be familiar with other fundamental aspects of RRSPs, including excess contributions and, as mentioned above, unused contributions. While there is an allowable lifetime $2,000 over-contribution, excess contributions are penalized at a rate of 1% per month.
The latter refers to contributions made to an RRSP, but that an individual either could not deduct or chose not to deduct. Either that, or they were contributions not designated as a Home Buyers’ Plan (HBP) or Lifelong Learning Plan repayment in a given year. These amounts can be carried forward to the next year so long as they do not exceed the individual’s deduction limit. The notion of unused contributions is distinct from unused deduction room, which simply refers to the difference between an individual’s RRSP deduction limit for a year less the amount actually deducted.
Strategic considerations for special situations
For most of your clients, RRSP calculations will be pretty straightforward: the contribution, deduction and deduction limit will all be the same. But in certain situations, it will make sense for them to alter the equation, as in the following examples.
Christine is a fast-rising marketing executive. In 2011, she made a $10,000 contribution to her RRSP, matching her deduction limit. But since she anticipates being in a higher income bracket in 2012 and beyond, she might want to deduct less than the full amount for 2011, carry forward the unused contribution, and then deduct it in a year when it will offset income being taxed at a higher rate. In other words, by postponing, she’ll receive a better tax break. And the money in her RRSP will continue to grow on a tax-deferred basis regardless of when she chooses to take the deduction.
There are a few qualifications to this approach. Christine is assuming that tax rates won’t change in future, and she is not accounting for the time value of money, which suggests that today’s smaller tax refund could be worth the same as a larger refund next year and beyond. And she simply may need the tax refund sooner rather than later.
Contributing regardless of income
Mary is an engineer who has been on maternity leave through 2011. She has no employment income for the year, but she has an RRSP deduction limit based on her 2010 income. If Mary has funds available, it might make sense to take a dollar cost averaging or consistent investing approach to her RRSP and make a contribution for 2011. That way, she’s able to continue sheltering income from her RRSP investments.
Offsetting all forms of income
Peter is currently unemployed, but he does have taxable income from non-registered investments and from a rental property. Since there’s no requirement that an RRSP deduction be used to offset employment income, provided he has unused RRSP deduction room, he can make RRSP contributions and claim the deduction from his other income. The only mitigating factor here is that Peter’s lack of employment income means he isn’t creating any new RRSP deduction limit room.
When a withdrawal makes sense
Tom earned a healthy income in 2011, but the company he works for is troubled and, not unreasonably, he fears a layoff in 2012. He anticipates that he may have looming cash needs. Given these circumstances, Tom might consider making a contribution to his RRSP before the end of February 2012, claiming the deduction on his 2011 return, and then making a withdrawal later in 2012 to cover his cash needs.
If he’s right and his employment is terminated partway through the year, the tax saved on the RRSP deduction could be more than the tax paid on the 2012 RRSP withdrawal. Tom will have to careful about withholding taxes on the withdrawal—ranging from 10% on amounts up to $5,000 and 30% on amounts of more than $15,000—since they will reduce his cash flow and could exceed his actual tax owing on the withdrawal.
Sally is an aggressive saver. She has an RRSP deduction limit of $6,000 for 2011, and while she made no contributions during calendar 2011, this January she put $10,000 into her plan. Technically, individuals are allowed to over-contribute to their RRSPs by $2,000. Amounts above that are subject to a tax penalty of 1% per month. Does Sally risk a tax penalty?
Actually, she doesn’t. When a contribution is made during the first 60 days of a calendar year, it’s not considered an over-contribution for the previous calendar year. Since Sally made no contributions during calendar 2011, she didn’t exceed her deduction limit. On her 2011 tax return, Sally will deduct $6,000, leaving $4,000 of unused contributions that she can carry forward to 2012 or beyond. Here’s where it gets a bit complicated for her: she will have to keep careful track of the amounts she may contribute during the remainder of 2012 to make sure that those amounts, plus that $4,000 already contributed, do not exceed her 2012 RRSP deduction limit by more than the allowable $2,000. In the meantime, that contribution will grow in her account on a tax-deferred basis.
How advisors can contribute
RRSP season is the perfect time for you as an advisor to emphasize the value you provide to your clients, by reinforcing your clients’ knowledge of deferred tax saving and alerting them to some of the useful strategies outlined above that can enhance their tax and savings positions. There’s even an easy reminder call tip to pass along about the contribution deadline: because 2012 is a leap year, the deadline is February 29 and not the usual March 1.