It’s a time-honoured ritual: In the first 60 days of the year, people across Canada gather up as much spare cash as they can, then dash to contribute to their registered retirement savings plans (RRSP) before the annual deadline hits.
There’s good reason to circle the cut-off date (it falls on March 1 in 2018): It’s your last chance to make a contribution that’s deductible against your income – thereby lowering your tax bill – from the previous tax year.
That tax deduction is just one of many benefits RRSPs offer.
Another? Tax deferral: Investments you hold inside your RRSP grow tax-free. And when you start taking your money out, after you’ve retired and converted your plan to a registered retirement income fund (RRIF), or used it to purchase an annuity, it’s taxed at your rate at the time of withdrawal, which should be lower than in your working years.
Sounds simple, right?
The truth is people still make plenty of blunders with their RRSPs. Today we’ll help you avoid 5 of the most common ones, with tips from Cliff Steele, a certified financial planner with Sun Life Financial.1
1. Not having a plan
You can hold many types of investments in an RRSP: stocks, guaranteed investment certificates, mutual funds, bonds and more.
Here’s a common scenario: In a scramble to make the deadline, you contribute cash to your RRSP, then life takes over and you don’t get around to actually investing the money. That’s 1 likely reason why cash makes up 60% of the average Canadian’s portfolio, according to the 2015 BlackRock Global Investor Pulse Survey.
“Remember, your money grows tax-deferred until you take it out, so you need to have growth assets [in your RRSP],” says Steele. “If you’re holding a lot of cash because you’re short on time [to make a plan], you should contact an advisor and find a way to deploy those assets.”
2. Making early withdrawals
Making RRSP withdrawals before retirement to, say, cover bills or make big purchases can have lasting consequences. For one, you'll forfeit the years of tax-deferred growth your money would have generated inside your plan.
And secondly, unless you withdraw funds under the Home Buyers’ Plan or the Lifelong Learning Plan, which let you borrow cash from your RRSP for your 1st home or post-secondary education (as long as you pay it back within a fixed timeframe), you’ll face a double tax hit.
The first comes on withdrawal: You’ll pay an immediate withholding tax of 10% on the first $5,000 (5% in Quebec); 20% for amounts between $5,000 and $15,000 (10% in Quebec); and 30% for more than $15,000 (15% in Quebec).
That’s not all.
“This will be reconciled at the end of the year,” says Steele. “So if your marginal tax rate is 35% and you took money from your RRSP at 10%, you’ll still owe that other 25% in taxes.”
Steele’s advice? Your RRSP should be your option of last resort.
“I encourage people to look at other arrangements, because there is virtually no situation where [early] RRSP withdrawals are the best option. If your income is higher, you’ll pay 30% or more in taxes versus a credit line at, say, 2% interest.”
You can put up to 18% of your previous year’s earned income in your RRSP, up to a maximum amount set annually. You can also carry forward room from previous years. (Your notice of assessment, which the CRA sends you after it’s analyzed your tax return, spells all of this out in dollars and cents.)
That sounds like a lot of latitude, but Steele still sees people go over the line occasionally. Company pension plans or deferred profit-sharing plans (DPSPs) are usually the culprit.
“If you have a pension – defined-benefit (DB) or defined-contribution (DC) – it will decrease your contribution limit,” he says. “Contributions to a DB or DC pension, as well as to a DPSP [even though a DPSP isn’t a pension], show up in the form of a pension adjustment in box 52 on your T4 slip. Often, people who over-contribute have a pension or a DPSP and they didn’t realize that these decrease their RRSP room.”
4. Spending the tax refund
Your RRSP contributions may result in a tax refund. And if you reinvest this cash in your RRSP without over-contributing, you can trigger a happy growth cycle for your nest egg, thanks to the magic of compounding.
"If you contribute your tax refund to your RRSP year after year [subject to the contribution limits], your RRSP will balloon, and your refund will keep getting bigger,” says Steele. “By reinvesting it, you’re getting tax dollars back via refunded tax dollars from the prior year.”
But if you spend your refund instead, you’re missing a great opportunity.
5. Misunderstanding the succession rules
Another common error happens when people name an adult child as their RRSP beneficiary when they still have a living spouse or common-law partner.
“What people often don’t realize is that RRSP assets transfer tax-free to [the RRSP of] a spouse at death, but payments made to [adult] children and others beyond a qualified spouse are taxable as income,” says Steele.
And you can’t escape the tax bill by leaving your RRSP to your estate, rather than naming a beneficiary, if you have no living spouse or partner. In that case, the CRA will add the fair market value of the assets held in your RRSP to your income in the year of your death, which can trigger a significant tax bill for your estate that could diminish its value for your heirs. Note that tax can be deferred if you died leaving a financially dependent child or grandchild under 18, or a financially dependent, mentally infirm child or grandchild of any age.
But that shouldn’t keep you away from RRSPs, says Steele. The key is to view your RRSP as a tool to sustain yourself in retirement, not to pass on a legacy.
1 Cliff Steele, CFP, © BBA, BMath, † The Steele Group Financial and Workplace Services Inc., Sun Life Financial advisor.
† Mutual funds offered by Sun Life Financial Investment Services (Canada) Inc.
Sun Life Assurance Company of Canada is a member of the Sun Life Financial group of companies.