It’s that time of year again. The Christmas tree has come down, you’ve dived into your new year’s resolutions and … now it’s RRSP time.
We all know it and we all go through the motions, but how many people actually think about whether the money they are putting away for retirement is being best utilized? That, of course, is where an independent advisor comes into play. They can help clients strategize their retirement plan so their money is working as efficiently as it can … for them.
First, though, it’s important to understand the fundamentals behind the Registered Retirement Savings Plan, which can hold a variety of investments like mutual funds, ETFs, GICs, bonds and stocks. When you “register”, you effectively enter into an agreement with the government; in exchange for putting money away for retirement, you get some benefits.
- You can defer tax on every dollar you contribute up to a specific amount
- You can defer tax on any investment gains you make within the RRSP, as long as the money stays in your account. In effect, you are growing money tax-free.
- Your tax bracket (marginal rate) is likely to be lower, especially for high-income people, when you start withdrawing money. This is when you’re taxed – by which time you’ll probably be retired.
Investors can contribute to your RRSP up until December 31 of the year they turn 71. They must then convert it to another vehicle, typically a Registered Retirement Income Fund (RRIF) from which they withdraw.
This year, the total amount that can be contributed is the lesser of $29,210 or 18% of your earned income in 2021. Importantly, you can carry forward any unused contribution room from previous years to top up the yearly amount. The deadline for contributing for 2021 is March 1, 2022.
All sounds rather wonderful, right? But simply throwing some savings into your RRSP when the mood takes you is not enough to secure your retirement. It requires more thought and strategy than that.
Is an RRSP the right savings vehicle for you?
There is, of course, another registered account alternative. The Tax-Free Savings Account (TFSA) is also designed to help people save – for retirement and other goals, like a house down payment. The big difference between the two is that with a TFSA, you pay income tax before you deposit the money into your account, so withdrawals are not taxed.
This account may appeal to people saving for more short-term goals or for seniors who don’t need the money immediately. There is no age limit on TFSAs, and you’re not required to make withdrawals, unlike with a RRIF. If you are in a lower tax bracket now than you will be when you retire, a TFSA could also be a better option.
What are you saving for and when do you need the money? A TFSA may be a better option but if retirement savings are your goal, there are some important strategic considerations to make.
- Maximize your contribution
In an ideal world, an investor uses their full allowable contribution limit each year. However, as we all know, life is not always smooth sailing, and some years bring greater expenses than others. If, therefore, you have accumulated unused contribution room, do not despair.
Firstly, investors can make a contribution in kind by redirecting non-registered investments, like mutual funds, to your RSSP. Be mindful, though, that a contribution from a non-registered account is a deemed disposition for capital gains purposes. In addition, you can take some funds from your TFSA to take your RRSP to its limit.
The other potential strategy when playing catch-up is to take out a loan. For example, if somebody had $20,000 of unused RRSP contribution room and they happen to have $10,000 to invest, and they are in a 50% tax bracket, they can take a $10,000 RRSP loan out and combine that with the $10,000 cash they have to make a $20,000 RRSP investment. That would generate a $10,000 reduction in tax, which would typically be a $10,000 refund, which can be used to pay off the RRSP loan.
If you are intent on taking it to the limit, remember that investing earlier in the year gives the money more time to compound, while making regular contributions can make it less painful when February comes around and you have to come up with a large lump sum.
- Take a look under the hood
Don’t be blahzay about what’s in your RRSP – it might cost you. Investors should ensure they hold interest-bearing investments inside their RRSP because they, and rental income, are fully taxable. However, if the account holds dividend income or capital gains, they are tax-advantaged income.
Why is this important? Capital gains and Canadian dividends are subject to a lower tax rate than other sources of income, but any income withdrawn from an RRSP is fully taxable at your top marginal tax rate. Therefore, keep these investments outside your RRSP in a non-registered portfolio.
- Resist the urge to dip in
There is, of course, nothing stopping anyone from dipping into their RRSP savings before retirement. However, it’s a decision that has consequences and should not be taken in haste – even in times of financial strife.
An RRSP does not work like an emergency fund – a TFSA is a better option for that as there are no tax implications. Any early RRSP withdrawal is taxed at your marginal rate and subject to withholding tax at the time of withdrawal. Currently, this rate stands at 10% for withdrawals up to $5,000, 20% for withdrawals between $5,000 and $15,000, and 30% for withdrawals over $15,000.
Another negative is that the investor can’t restore the contribution room, limiting your RRSP ceiling.
There are special situations that allows someone to access their RRSP without these penalties – the Home Buyers’ Plan and the Lifelong Learning Plan, which both enable tax-free withdrawals with the ability to re-contribute. Neither of these, however, can make up the lost investment growth. The moral: think hard, and long, before making early RRSP withdrawals and explore other options first.
- Spousal RRSPs
With the pension-income splitting rules available right now, people have often shied away from spousal RRSPs but there remain some nice “tax-break” benefits on offer.
Spousal RRSPs are helpful when one spouse has a high income and the other has a very low one, meaning their income can be equalized. This is a particularly attractive option if the higher-income spouse has a good defined benefit pension plan on retirement and the other spouse does not. So, once the couple reaches 65, if the lower-income spouse needs to withdraw some funds, that money would be taxed at the lower-income level.
It's worth remembering, too, that under pension-income splitting only 50% of your pension income can be applied to your spouse, whereas if you put money into a Spousal RRSP, the full amount of the withdrawals is taxable income to your lower-income partner.
Another benefit arises if one spouse is older than the other. The older spouse is allowed to continue to make RRSP contributions to the spousal plan until the end of the year the younger spouse turns 71, providing the latter has qualifying earned income and available contribution room.
At the other end of the age spectrum, a spousal RRSP can be also useful for couples who are first-time home buyers. For example, if the higher-earning spouse sets up his or her own RRSP plus a spousal RRSP, then the couple can borrow from both of those for the homebuyer’s plan.
Once the fund is more than three years old, people can borrow $35,000 tax-free from each RRSP – as long as they repay it within fifteen years – for their first home. If the fund is less than three years old, they’ll need to pay taxes on that withdrawal.
- Don’t hold yourself back
Two elements of your strategy that may, on paper, seem like common sense could easily be overlooked. The first is to be tax efficient. Well, obviously, I hear you say, but sometimes decisions can go against an investor’s instinct. For example, if you expect to have a meaningfully higher income in the years ahead, you can still make an RRSP contribution but defer taking the tax deduction until you’re in a higher tax bracket.
The second thing that has the potential to hamstring an investor is being too conservative. Limiting your RRSP holdings to fixed-income investments like GICs leaves the account open to inflation risk. Instead, a properly balanced investment portfolio, which incudes equities, can not only protect you against inflation but provide much better long-term growth potential.
Thinking about your RRSP plan outside of the final two weeks of February can help an investor make less-pressured decisions, while an investment professional will assist you in setting out and maximising your retirement strategy. You’ve worked hard for your money, don’t hurt your golden retirement years by making poor RRSP decisions.
