Let’s Break Down RRSPs

Let’s Break Down RRSPs

For this month, I am going to detour from my “Path to Business Ownership – An Accountant’s Viewpoint” article series and explore a timely subject I get asked about regularly this time of year – RRSPs.  The most common registered retirement savings plan (RRSP) question I receive from clients is simply whether an RRSP contribution is a good idea for them.  Unfortunately, there is no simple answer, as there are several factors to consider before deciding whether to make an RRSP contribution.

The most obvious advantages to an RRSP include: the tax deduction generated, the accumulation of investment income tax-free, and the ability to withdraw funds tax-free under the home buyers’ plan and the lifelong learning plan (although these withdrawals do need to be repaid, otherwise they become taxable).  Overall, use of RRSP investing allows an individual to maximize their investment due to the tax-free growth and up front tax deductions, compared to individuals who make the same investments outside of an RRSP plan.

An RRSP contribution is really only a tax deferral

Before we delve any further into this, it is important to clarify the tax implications around RRSPs.  An RRSP contribution is really only a tax deferral, as the funds are fully taxable once withdrawn from the plan.  This means you are able to claim a deduction in the year you make a contribution, however, you will be taxed on any future withdrawals from the plan.  So before any final determination is made on whether a contribution makes sense, consider the following:

  • Taxable income in the year of contribution – individuals with higher taxable income (especially those in the 50% marginal tax bracket) will benefit most from an RRSP contribution. For those in higher tax brackets, there is a larger tax benefit compared to those at a lower tax rate.  For instance, a $10,000 RRSP deduction will save the high income individual $5,000 in taxes compared to $2,500 for a taxpayer at the 25% marginal tax bracket.  For savvy investors, the ideal scenario is to take the RRSP deduction (make the RRSP contributions) when you’re at the high marginal tax bracket, and withdraw RRSP funds as income when you are in a lower tax bracket.
  • Spouse’s taxable income – if your spouse has a smaller investment portfolio than you, a spousal contribution provides an opportunity to income split in the future. This is best utilized with the higher tax rate individual making a spousal contribution on behalf of the lower tax rate spouse.  In this situation, there is a current year deduction for the higher tax rate individual, and in future years, the funds withdrawn will be taxed at the spouse’s lower tax rate.  A few early withdrawal restrictions do apply.
  • When will the funds likely be withdrawn from the RRSP? – it doesn’t make sense to contribute in a year in which you plan on withdrawing funds, unless it is under the home buyers’ plan or lifetime learning plan, otherwise you waste available contribution room.
  • Is there enough RRSP contribution room available? An over-contribution can result in stiff penalties.  You should refer to your CRA notice of assessment for your available contribution room.
  • Age of the contributor – in the year you turn 71 you must convert your RRSP to a RRIF, however, if your spouse is under 71 then you may continue making spousal contributions until such time as they turn 71.

Often during the early years of your work career, your taxable income is quite low and RRSP contributions may not be your best investment.  Tax deductions during your lower income earning years really don’t save you that much in taxes, and down the road, you will likely be in a higher tax bracket when you begin withdrawing funds.  In periods of low taxable income you might want to consider using your Tax-Free Savings Account (TFSA) as a means of retirement planning.

It is important to consider your best tax option, and talk to your accountant or advisor about what makes sense for your particular situation.

jonathan-mcgraw-bdoArticle provided by:

Jonathon (Tug) McGraw, BCOMM, CPA, CA

BDO Canada LLP

Jonathan can be reached at: jmcgraw@bdo.ca

 

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