‘Tis the season! RRSP season, that is. Time to get ready for the media’s annual dose of advertisements about saving for retirement. While we all need to be smart about planning for retirement, the reality is that there are a lot of myths and misconceptions about the RRSP – Canada’s most popular retirement savings plan.
Rather than focus on a specific ‘RRSP season’, we encourage our clients to make regular contributions to their registered and non-registered accounts throughout the year.
However, if you haven’t yet contributed to your RRSP in 2016, there’s still time to get a deduction for the 2016 tax year. So check out our RRSP top 10 list for things you need to know (and then set up automatic contributions for 2017, and you won’t have to worry about RRSP season next year).
1. What is the RRSP contribution limit for the 2016 tax year?
The 2016 RRSP Contribution Deadline is March 1, 2017, and the 2016 RRSP Contribution Limit: $25,370. So how much would have you to make in order to actually contribute that amount? You’d need an income of at least $140,994 in 2015 to contribute that much in 2016!
Of course, that’s assuming there was no carry-forward from the previous year. This is actually a great feature of RRSPs – any unused contribution from one year is simply carried forward to the next, indefinitely. Until you reach age 71, that is. December 31st of the year you reach age 71 is age limit for RRSP contributions for everyone.
2. What is “earned income”?
So, how is the RRSP limit determined? Your RRSP contribution limit for the current year is calculated as 18% of your “earned income” from the previous year. Earned income generally includes things like employment income, business income, rental income, and any (taxable) spousal support you have received. So what isn’t included in earned income? Income like CPP pension benefits, Old Age Security benefits, pension income, or TFSA, RRSP or RRIF withdrawals.
3. Should I contribute to an RRSP or TFSA?
Of all the debates regarding RRSPs, this one seems to be the most common. RRSP or TFSA, which is better? Unfortunately, it’s a bad question, and for a number of reasons. First, it’s not that one is universally better than the other. Let’s ask a better question: What’s the best strategy for you at this time? Furthermore, it’s a bad question because it’s phrased as an “or” question. Why does it have to be one “or” the other? It doesn’t. In many cases, it will make sense to contribute to both a TFSA and an RRSP, rather than neglect one in favour of the other.
Remember that RRSP contributions give you a tax deduction. TFSA contributions do not. So if you’re in need of a deduction, the RRSP may be more attractive. However, if your income is low, you may actually be in a higher marginal tax rate in retirement than you are now. That means you’ll pay more to take your money out of your RRSP than you saved putting it in there.
4. What type of investments are allowed in my RRSP and TFSA?
You can hold the same stuff in RRSP and TFSA accounts – stocks, bonds, mutual funds, ETFs, etc. Although many banks talk about such things as a “TFSA rate” or an “RRSP rate,” that language is misleading. Think of an RRSP and a TFSA as baskets. You can put investments into those baskets, which then determines your investment returns. But the baskets themselves are not investments. Equally misleading is the “S” in TFSA. It’s not really a savings account, it’s an investment account.
5. Why should I pay attention to my marginal tax rate?
The old assumption about RRSPs was that your income, and therefore your marginal tax rate (MTR) would be significantly lower during retirement than it was during your working years. We’re beginning to see evidence that, for many investors, that’s simply not true. If your MTR is higher in retirement, you’ll pay more tax taking money out of your RRSP than you saved when contributing.
Of course, the tax sheltered growth inside the RRSP is still highly desirable. But for those who are in a low income bracket, and hence a low MTR, it may make sense to postpone the RRSP contribution to a later year. When your income is higher, the income tax deduction will be more powerful.
6. What’s the deal with “asset location”?
Wait a second, don’t you mean asset allocation? Well, that’s important too. But while asset allocation generally refers to the mix of stocks, bonds, and cash in your portfolio, asset location refers to where you hold those different asset classes. Remember, investment returns are essentially de-natured, and lose their identity inside an RRSP. Capital gains and dividends lose their favourable tax treatment, and every dollar taken out is taxed as regular income (100% inclusion).
To the extent possible, it’s generally a good idea to keep your fixed income investments inside your RRSP, and your equities (which generate tax-friendly capital gains and dividends) in your non-registered account.
7. Should I use some of the money in my RRSP to buy a house?
Like so many other personal finance decisions, it depends. The RRSP Homebuyer’s Plan (HBP) basically allows you to borrow from your RRSP without paying tax on the withdrawals. Of course, there are a few conditions attached, and you have to re-contribute the amount withdrawn over a 15-year schedule of repayments.
However, just because you can withdraw $25,000 from your RRSP doesn’t mean you should. While the extra cash can certainly help with the purchase of a new home, withdrawing from your RRSP can also significantly impair your retirement savings. Make sure you crunch the numbers to make an informed decision.
8. Should I use a spousal RRSP?
A spousal RRSP is basically an income splitting tool, which can help a couple save taxes if one spouse’s income is significantly higher than the other’s. The general idea is to shift taxable income away from the higher income spouse, and into the hands of the lower income spouse, thereby reducing the overall household tax bill.
So, how does it work? A spousal RRSP is one in which you contribute to an RRSP for your spouse, and claim the deduction for yourself. The higher income spouse makes the contribution and gets a larger refund (due to higher income and higher tax rate). The lower income spouse owns the RRSP and is taxed when the money is withdrawn (at a lower tax rate due to their lower income).
9. Why is my RRSP balance misleading?
Remember, RRSP withdrawals are fully taxable. And that refund you scored when you made a contribution, will eventually have to be repaid when you make a withdrawal. (Just one more reason why blowing your RRSP refund on a vacation is generally not a good idea!) With an RRSP, it’s not that taxes are avoided, they’re simply postponed. This may seem like a subtle point, but it gets investors in trouble all the time.
Looking at your RRSP balance gives somewhat of a false impression, and can mislead investors into thinking they have more money than they actually have. This is analogous to your salary, and the same reality applies to your RRSP – Whatever your RRSP balance, you don’t actually have that much money, in the sense that you can’t actually spend it. Don’t forget to account for taxes!
10. What’s an RRSP “exit strategy”?
As we know, many Canadians have no RRSP plan at all. And of those who do, while there may be a plan for contribution, there is seldom a plan for withdrawal. However, all funds inside an RRSP must be withdrawn at some point.
So, what’s the big deal? Well the problem is that every dollar withdrawn from an RRSP is subject to full inclusion, and taxable as regular income. On top of other taxable income sources (such as an employer pension, CPP, and OAS), regular withdrawals from an RRSP (or RRIF) can be highly inefficient. Remember, a plan for eventual withdrawal – that is, an RRSP exit strategy – is just as important as a plan for contribution.
Want more information on RRSPs? Check out 11 RRSP Mistakes to Avoid.