RRSPs 102: Beyond the Basics
Part 1
I don’t want to insult your intelligence or induce a potentially fatal sense of post-holiday boredom by repeating what a lot of you already know about RRSPs. On the other hand, you know what they say about “assume” and what it makes of “u” and me. Accordingly, this is what I propose: I’ll run through a basic summary as quickly as possible and will even try to sprinkle in a few jokes to liven your day before getting to some of the (at least to me) more interesting stuff. I’ll then describe a couple more advanced planning techniques to reward you for making it to the bitter end but will hold back the rest until my next article in the hopes that this will both leave you clamouring for more and reduce your eyestrain in the meantime.
RRSPs - The Down And Dirty
In a nutshell, everyone with employment or business income (which includes things like book royalties and rental income, too) earns RRSP room for the next tax year. This room is 18% of the previous year’s employment income, up to a set limit, which will be $25,370 for 2016, plus whatever room you’ve earned in the past but not used. Your cumulative total is recorded for you on your Notice of Assessment, which the government sends to taxpayers each year after they have filed their tax returns. You can also phone the Canada Revenue Agency (CRA) to get this info or, as I do, register with them via their “My Account Program” so you can login any time your heart desires to get this and other tax information.
Why would you want to make contributions? There are a lot of reasons, including but not limited to:
- You can claim a deduction for every dollar contributed, which is particularly enticing if you’re at a high marginal tax rate now and expect to be at a lower rate when it’s withdrawn and finally taxed;
- The money inside an RRSP grows without taxation until withdrawal, which means it has the chance to compound or grow a lot quicker than on investments that are taxed along the way, such as when you sell a security or earn dividends in a non-registered account;
- Money inside an RRSP is creditor-protected in many circumstances, depending on your province and how long it has been inside your RRSP before your creditors come calling;
- You can avoid probate fees, delays and some other estate-planning problems at death by naming beneficiaries directly on the accounts; and,
- RRSPs are a great income-splitting vehicle, both during and before retirement in some cases, particularly through the use of Spousal RRSPs (as discussed later).
In summary, the basic tax side of things works like this. If you contribute $10,000 to your RRSP for that tax year (which can actually be generally as late as two months after year end) and were in a 40% tax bracket, you have $10,000 invested for your retirement compounding (hopefully. You then have either a $4,000 tax refund or are paying $4,000 less in taxes. If you decided to pull it out a year later when you were at a 20% rate, you’d still be $2,000 ahead even if your original investment hadn’t earned you a dime in the interim.
Sounds great? Well, in most cases, I’d agree, but there are some exceptions to the rule and some drawbacks to RRSPs that you need to know and factor into your planning. The bigger drawbacks may come during retirement; once you do start withdrawing RRSPs, usually after converting them to something called a RRIF (which must be done before year’s end when you turn 71, and you have to pull out a minimum amount each year, even if you don’t need the money). This minimum is a set percentage of the January 1 value of your investments and this percentage increases yearly as you (or your partner, as you can use either spouse’s age when the RRIF is set up) grow older. These mandatory withdrawals can push people into higher tax brackets and mess up their OAS Pension, which are clawed back when a person’s taxable income gets too high. Finally, at the last of you or your spouse’s deaths (with a couple exceptions), the remaining balance is added to your income that year, which often means a huge final tax bill. A large RRSP or RRIF means that a lot of it will be taxed at the highest marginal tax rate, which can top 50% in some provinces, even though you may have received a much lower tax deduction when you contributed in the first place.
To some people, the drawbacks aren’t worth the rewards. Sometimes, they are right, particularly if they aren’t in high tax brackets. More often, however, I think some of the drawbacks can be addressed through careful planning, such as making withdrawals earlier in retirement or stopping contributions when people are in similar tax brackets now than they will be in retirement, or by using some of the advanced techniques I will talk about below and in my next article. I also agree that big tax bills at death aren’t a wonderful thing but I can think of far worse alternatives, such as running out of money years earlier or having to worry and stress your way through retirement in order to make ends meet. In that way, I see RRSPs as something of an insurance policy; you put the money in to insure against running short in retirement and the cost you might pay to do so is a high tax bill at death, along with potentially some higher tax bills during retirement than would otherwise have been the case.
Before going into some of the advanced ideas, I need to also talk about some special RRSP rules that could affect some of you or you’ll need to know as part of your advanced planning package.
Pension Adjustments And Pension Adjustment Reversals
If you are earning a work pension, this will cut into how much RRSP room you’ll get going forward, as the government doesn’t want people who are getting all the perks of an employer pension to be able to also earn as much RRSP contribution room from that year’s salary as someone having to fund 100% of their own retirement. Accordingly, your employer will report something called a “Pension Adjustment” on your tax slip that is deducted from how much new RRSP room you would have otherwise earned that year. In other words, if you would have otherwise earned $18,000 in new RRSP room but had a $14,500 Pension Adjustment, you would only end up with $3,500 in new RRSP room for the next tax year.
On the other hand, if you ever leave your employer and decide to “commute” your pension (convert it to a special type of RRSP with withdrawal restrictions), it is quite possible that you will get some extra RRSP room to use in the future. Upon commuting your pension, your former pension plan will crunch some numbers and see if you are entitled to something called a “Pension Adjustment Reversal”. If you do, you will get that much back in extra RRSP room to use in the future as the original Pension Adjustment was calculated on the assumption that you wouldn’t cash out your pension before retirement.
Spousal RRSPs
This option is a great way for families to minimize their tax bills going forward both immediately and during retirement through income splitting. It works as follows: rather than contributing to your own RRSP, you can contribute to a separate ”Spousal RRSP” created just for this purpose in your spouse or common-law partner’s name. Any money contributed by you is deducted on your return and uses up your RRSP contribution room, even though the account is registered in your spouse’s name. On the other hand, provided that three December 31sts have passed since your last contribution to the spousal plan (with some minor exceptions), withdrawals will be taxed 100% in your spouse’s hands. If your spouse is a lot younger than you, it also means delaying the age from when you have to start making any withdrawals until that spouse turns 72, which can also make a huge difference for some couples who want more flexibility as to how much they take out each year.
Part 2
Advanced Techniques
Now that we’ve hopefully laid the groundwork, we’re finally ready to look at some additional ways to milk every last dollar of tax savings out of your RRSPs so that your retirement can feature far more caviar and far less Kraft Dinner.
The Spousal RRSP Shuffle
Even if you hate RRSPs or figure that the ones already registered in your name are already large enough, what would you say about some additional pre-retirement savings? This technique is designed for predominately single-income families and it works like this: The earning spouse contributes to a Spousal RRSP and then waits until 3 December 31sts have passed since the last contribution. This can be as little as 2 years and a few days if done correctly. For example, someone ponying up the RRSP loot by December 31 2016 would only have to wait until January 1, 2019 until any withdrawals are taxed exclusively in the receiving spouse’s hands. Although paying tax is never a wonderful thing, the thought of the contributing spouse getting potentially a 50% plus tax deduction in 2016 (or 47.7% in B.C.) makes the thought of the receiving spouse paying perhaps 20% tax on the withdrawal in 2019 a little more palatable. Moreover, if the receiving spouse is not earning any other income, some of the withdrawals might be completely tax-free.
I also like this technique for families that would otherwise struggle to find enough money for the single income earner to max out RRSP contributions, as the money eventually withdrawn in the low-income spouse’s hands can ultimately free up more money so the income-earning spouse can contribute more in the future than finances would otherwise allow them to contribute. For couples planning to retire at different times, this technique can also be a great way to fund an early retirement for one of them, particularly if they are able to start spousal contributions several years in advance.
Noting that you need to wait until three December 31sts have passed until the money is taxed in your spouse’s hands, you will have to be sure to turn off the funding tap with this requirement in mind.
Strategic Funding Or Claiming Of Deductions
Although most of us (rightly) decide to claim our RRSP contributions in the tax year we make them, this isn’t our only choice. Ultimately, although we have to report contributions during the tax year they are made, we can choose when to claim our deduction. If it so happens that we expect to be in a higher tax bracket during the next tax year, it might make sense to wait until then before claiming this year’s contributions. Although it means waiting an extra year to get the money, it might be a price worth paying if it means getting substantially more. For example, if a $10,000 contribution nets a $3,000 refund this year but would pay $4,100 next year, you would need to make over a 33% after-tax return on your money if you claimed your contribution immediately rather than waiting until you got that big raise or triggered a capital gain by selling a rental property or stocks in the year to come.
A variation on this strategy is simply funding more during high income years rather than during low ones. Of course, the means to do this is usually more readily available when you’re a senior VP rather than a mail clerk, but I still prefer regular systematic contributions rather than high-income-year dump-ins, because people tend to contribute more when they do it regularly; this allows extra compounding inside the plan because you benefit from dollar-cost averaging (a fancy way of saying that you reduce the risk of really bad market timing).
Not able to fund both your TFSAs and RRSPs? Another variation on this strategy is to get all the benefits of regular contributions and compounding while you’re planning for next year’s raise (and the resulting tax hit) by putting more into your TFSA and then rolling that into your RRSP when your ship comes in. Even better, if your investments grow inside your TFSA, you might be able to contribute more (and get a bigger deduction) when you eventually do fund up your RRSP. From a practical sense, however, this alternative might not be worth the extra hassle for smaller planned contributions.
Although strategically making and claiming contributions works really well while you’re planning for promotions or raises, retirees who are still eligible to contribute to their own or a spousal RRSP during their golden years might want to keep this strategy handy for those occasional high income years, such as when finally selling the family cabin. Over age 71, and thus unable to contribute to your own RRSP? All may not be lost if your spouse hasn’t reached this milestone; spousal contributions are allowed until that time if you have the room. Accordingly, depending on the age of that younger man or woman in your life, you could theoretically keep contributing until you were 100 if you have the room or continue to earn eligible income!
Conclusion
At this point, my hope is that you’ve learned enough about RRSPs to be able to talk about them intelligently at a dinner party, although I’d understand if you’d rather not. Although they have their drawbacks, they are still valuable tools for many taxpayers, which is why they are the backbone of many retirement plans. My goal in the second half of this article and the one to follow is to build on the basics so you can build your bank accounts, too, through additional tax savings. Until then, may your 2016 be a wonderful one.
Colin S. Ritchie, LL.B., CFP, CLU and FMA is a Vancouver-based fee-for-service lawyer and financial planner who does not sell investment or insurance, just advice. To find out more, visit his website at www.colinsritchie.com.